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The term “Management Accounting” is of recent origin. It was first coined by the British
Team of Accountants that visited the U.S.A. under the sponsorship of Anglo-American
Productivity Council in 195 with a view of highlighting utility of Accounting as an
“effective management tool”. It is used to describe the modern concept of accounts as a
tool of management in contrast to the conventional periodical accounts prepared mainly
for information of proprietors. The object is to expand the financial and statistical
information so as to throw light on all phases of the activities of the organisation.

All techniques which aim at appropriate control, such as financial control, budgeted
control, efficiency in operations through standard costing, cost-volume-profit theory etc,
are combined and brought within the purview of Management Accounting.

Management Accounting evolves a scheme of accounting which lays emphasis on the

planning of future (logical forecasting), simultaneously finding the deviations between
the actual and standards. Another significant feature of Management Accounting is
reporting to top-management. Finally, accounting information should be presented in
such a way as to assist the management in the formulation of policy and in the day-to-
day conduct of business. For example, the published accounts of business concerns do
not furnish management with information in a form that suggest the line on which
management policies and actions should proceed. It requires further analysis
classification and interpretation before the management can draw lessons from them for
their guidance and action.


Management Accounting may be defined as “the presentation of accounting information

in such a way as to assist the management in the creation of the policy and day-to-day
operation of an undertaking” – Management Accounting of the Anglo-American to

The Institute of Chartered Accountants of England has defined it –

“Any form of accounting which enables a business to be conducted more efficiently can
be regarded as Management Accounting”.

Robert N. Anthony has defined Management Accounting as follows-

“Management Accounting is concerned with accounting information that is useful to


According to American Accounting Association, “Management Accounting includes the

methods and concepts necessary for effective planning for, choosing among alternative
business actions and for control through the evaluation and interpretation of
performance”. This definition is fairly illustrative.

According to Kohler, Forward Accounting includes “Standard costs, budgeted costs and
revenues, estimates of cash requirements, break even charts and projected financial
statements and the various studies required for their estimation, also the internal
controls regulating and safeguarding future operating.”

Blending together into a coherent whole financial accounting, cost accounting and all
aspects of financial management”. He has used this term to include “the accounting
methods, systems and techniques which, coupled with special knowledge and ability,
assist manageme4nt in its task of maximizing profits or minimizing losses.” – James

Thus all accounting which directly or indirectly providing effective tools to managers in
enterprises and government organizations lead to increase in productivity is
“Management Accounting.”


The basic objective of Management Accounting is to assist the management in carrying

out its duties efficiently.

The objectives of Management Accounting are:

1. The compilation of plans and budgets covering all aspects of the business e.g.,
production, selling, distribution research and finance.
2. The systematic allocation of responsibilities for implementation of plans and
3. The organization for providing opportunities and facilities for performing
4. The analysis of all transactions, financial and physical, to enable effective
comparisons to be made between the forecasts made and actual performance.
5. The presentations to management, at frequent intervals, of up-to-date
information in the form of operating statements.
6. The statistical interpretation of such statements in a manner which will be of
utmost assistance to management in planning future policy and operation.

To achieve the above objectives, Management Accounting employs three principles

devices, viz.,-

1. Forward Looking Principle – basis on the past and all other available data,
forecasting the future and recommending wherever appropriate, the course of
action for the future.
2. Target Setting Principle – fixation of an optimum target which is variously
known as standard, budget etc., and through continuous review ensuring that the
target is achieved or exceeded.
3. The Principle of Exception – instead of concentrating on voluminous masses of
data, Management Accounting concentrates on deviations from targets (which
are usually known as variances) and continuous and prompt analysis of the
causes of these deviations on which to base management action.


The scope of Management Accounting is wide and broad based. It encompasses within
its fold a searching analysis and branches of business operations. However, the
following facets of Management Accounting indicate the scope of the subject.
1. Financial Accounting.
2. Cost Accounting
3. Budgeting & Forecasting
4. Cost Control Procedure
5. Statistical Methods
6. Legal Provisions
7. Organisation & Methods

1. Financial Accounting: This includes recording of external transactions covering

receipts and payments of cash, recording of inventory and sales and recognition
of liabilities and setting up of receivables. It also preparation of regular financial
statements. Without a properly designed accounting system, management
cannot obtain full control and co-ordination.
2. Cost Accounting : It acts as a supplement to financial accounting. It is
concerned with the application of cost to job, product, process and operation. It
plays an important role in assisting the management in the creation of policy and
the operation of undertaking.
3. Budgeting & Forecasting: These are concerned with the preparation of fixed
and flexible budgets, cash forecast, profit and loss forecasts etc., in co-operation
with operating and other departments. Management is helped by them.
4. Cost Control Procedure: It is concerned with the establishment and operation
of internal report in order to convert the budget in to operating service.
Management is helped by them by measuring actual results budgetary standards
of performance.
5. Statistical Methods : These are concerned with generating statistical and
analytical information in the form of graphs charts etc. of all department of the
organization. Management need not waste time in understanding the facts and
more time and energy can be utilized in sound plans and conclusions.
6. Legal Provisions: Many management decisions depend upon the provisions of
various laws and statutory requirements. For example, the decision to make a
fresh issue of shares depends upon the permission of controller of capital issues.
Similarly, the form of published accounts, the external audit the authority to float
loans, the computation and verification of income, filing tax returns, making tax
payments for excise, sales, payroll income etc., all depend on various rules and
regulations passes from time to time.
7. Organization & Methods: They deal with organization, reducing the cost and
improving the efficiency of accounting as also of office operations, including the
preparation and issuance of accounting and other manuals, where these will
prove useful.

It is clear that Management Accounting has a vital relation with all those areas
explained above.


The functions of management accounting may be said to include all activities connected
with collecting, processing, interpreting and presenting information to management. The
Management Accounting satisfies the various needs of management for arriving at
appropriate business decisions. They may be described as follows:

1. Modification of Data:

Accounting data required for decision – making purposes is supplied by management

accounting through resort to a process of classification and combination which enables
to retrain similarities of details without eliminating the dissimilarities (e.g.) combination of
purchases for different months and their breakup according to class of product, type of
suppliers, days of purchase, territories etc.

2. Analysis & Interpretation of Data:

The data becomes more meaningful with the analysis and interpretation. For example,
when Profit and Loss account and Balance Sheet data are analyzed by means of
comparative statements, ratios and percentages, cash-flow-statements, it will open up
new directions for its use by management.

3. Facilitating Management Control

Management Accounting enables all accounting efforts to be directed towards control of

destiny of an enterprise. The essential features in any system of control are the
standards for performance and measure of deviation therefrom. This is made possible
through budgetary control and standards costing which are an integral part of
Management Accounting.
4. Formulation of Business Budgets:
One of the primary functions of management is planning. It is done by Management
Accounting through the process of budgeting. It involves the setting up of objectives,
and the selection of the most appropriate strategies by comparing them with reference
to some discriminating criteria. Probability, Probability, forecasting, and trends are some
of the techniques used for this purpose.

5. Use of Qualitative Information:

Management Accounting draws upon sources, other than accounting, for such
information as is not capable of being readily convertible into monetary terms. Statistical
compilations, engineering records and minutes of meeting are a few such sources of

6. Satisfaction of Informational Needs of Levels of Management:

It serves management as a whole according to its requirements it serves top middle and
lower level managerial needs to subserve their respective needs. For instance it has a
system of processing accounting data in a way that yields concise information covering
the entire field of business activities at relatively long intervals for the top management,
technical data for specialized personnel regularly and detailed figures relating to a
particular sphere of activity at short intervals for those at lower rungs of organizational

The gist of Management Accounting can be expressed thus, it is a part of over all
managerial activity – not something grafted on to it from outside – guiding and servicing
management as a body, to derive the best return form its resources, both the itself and
for the super system within which it functions.

From the above discussions, one may come to the following conclusions about the
fundamental approach in Management Accounting.

Firstly, the Management Accounting functions is a managerial activity and it puts its
finger in very pie without itself making them it guides and aids setting of objectives,
planning coordinating, controlling etc. But it does not itself perform these functions.

Secondly it serves management as a whole – top middle and lower level – according to
its requirements. But in doing so it never fails in keeping in focus the macro-approach to
the business as a whole.
Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach is to split
all costs and benefits into two groups – measurable and non measurable. It is easy to
deal with measurable costs which are expressed in terms of money. But there are
several ventures such as office canteens where the cost-benefits may not be monetarily


Comparatively, Management Accounting is a new discipline and is still very much in a

state of evolution. There fore it comes across the same impediments as a relatively new
discipline has to face-sharpening of analytical tools and improvement of techniques
creating uncertainty about their applications.

1. There is always a temptation to make an easy course of arriving at decision to

intuition rather than taking the difficulty of scientific decision-making.
2. It derives its information from financial accounting, cost accounting and other
records. Therefore, strength and weakness of Management Accounting depends
upon the strength and weakness of basic records.
3. It is one thing to record, interpret and evaluate an objectives historical event
converted into money figures, while it is something quite different to perform the
same function in respect of post possibilities, future opportunities and
unquantifiable situation. Execution of the conclusions drawn by the management
accountant will not occur automatically. Therefore, a continuous effort to achieve
the goal must be made at all levels of management.
4. Management Accounting will not replace the management and administration. It
is only a toll of management. Of course, it will save the management from being
immersed in accounting routine and process the data and put before the
management the facts deviating from the standard in order to enable the
management to take decisions by the rule of exception.


The terms financial accounting, and management accounting, are not prices description
of the activities they comprise. All accounting is financial in the sense that all accounting
systems are in monetary terms and management, of course, is responsible for the
content of financial accounting reports. Despite this close interrelation, there are some
fundamental differences between the two and they are:

1. Subject Matter : Managements need to focus attention on internal details is the

origin of the basic differences between financial accounting and management
accounting. In financial accounting, the enterprise as a whole is dealt with while,
in management accounting, attention is directed towards various parts of the
enterprise which is regarded mainly as a combination of these segments. Thus
financial statements, like balance-sheets and income statements, report on the
overall status and performance of the enterprise but most management
accounting reports are concerned with departments products, type of inventories,
sales or other sub-division of business entity.
2. Nature – Financial accounting is concerned almost exclusively with historical
records whereas management accounting is concerned with the future plans and
policies. Management’s interest in the past is only to the extent that it will be of
assistance in influencing company’s future. The historical nature of financial
accounting can be easily understood in the context of the purposes for which it
was designed but management accounting does not end with the analysis of
what has happened in the past and extends to the provision of information for
use in improving results in future.
3. Dispatch – In Management Accounting, there is more emphasis on furnishing
information quickly then is the case with financial accounting. This is so because
up-to-date information is absolutely essential as a basis for management action
and management accounting would lose much of its utility if information required
the time lag between the end of accounting period and the preparation of
accounting records for the same, it has not been, and cannot be, totally
4. Characteristics – Financial accounting places great stress on those qualities in
information which can command universal confidence, like objectivity, validity
absoluteness, etc. whereas management accounting emphasizes those
characteristics which enhance the value of information in a variety of uses, like
flexibility, comparability etc. This difference is so important that a serious doubt
has been raised as to whether both the types of characteristics can be preserved
within the same framework.
5. Type of Data Used Financial accounting makes use of data which is historical
quantitative, monetary and objective, on the other hand management accounting
used data which is descriptive, statistical subjective and relates to future.
Therefore management accounting is not restricted, as financial accounting is, to
the presentation of data that can be certified by independent auditors.
6. Precision – There is less emphasis in precision in management accounting
because approximations are often as useful as figures worked out accurately.
7. Outside Dictates – As financial accounting ahs been assigned the role of a
reference safeguarding the interests of different parties connected with the
operation of a modern business undertaking, outside agencies have laid down
standards for ensuring the integrity of information processed and presented in
financial accounting statements. Consequently, financial accounting statements
are standardized and are meant for external use. So, far as management
accounting is concerned, there is no need for clamping down such standards for
the preparation and presentation of accounting statements as management is
both the initiator and user of data. Naturally, therefore, management accounting
can be smoothly adapted to the changing needs of management.
8. Element of compulsion – These days, for every business, financial accounting
has become more or less compulsory indirectly if not directly, due to a number of
factors but a business is free to install, or not to install, a system of management

The gradual growth of management accounting has brought with it a recognition of the
desirability of segregating the accounting function from other activities of a secretarial
and financial nature in order to make possible a more accurate accounting control over
multifarious, complex and sprawling business operations. As a natural corollary,
controller has come into being by way of a skilled business analyst who, due to his
training and experience, is the best qualified to keep the financial records of the
business and to interpret these for the guidance of the management.

It is not surprising, therefore, that controllership function has developed pari passu with
the development of management accounting so much so that there is a tendency to
record the two as synonymous. In a way, this is true because of controller in the United
States does all that management accounting is expected to accomplish, in fact,
controller is the pivot round which system of management accounting revolves.

Generally speaking, controllership function embraces within its broad sweep and wide
curves, all accounting functions including advice to management on course of action to
be taken in a given set of circumstances with the object of completely eliminating the
role of intuition in business affairs.


There is no precise concept of controllership as it is still in an evolutionary state. Even if

the concept was possible of being described, it cannot be said that, wherever a
controller is in existence, he exercises all the functions that a theoretical controller is
expected to do because the real meaning of the term is dependent upon the agreement
between him and the undertaking the seeks to serve. However, the controllers’ Institute
of America has drafted a seven-point concept of modern controllership. The hallmarks
of the concept are:

i. To establish, coordinate and administer, as an integral part of management, an

adequate plan for the control of operations. Such a plan would provide, to the
extent required in the business, for profit planning, programs for capital investing
and financing, sales forecast, expense budgets and cost standards, together with
the necessary procedure to effectuate the plan.
ii. To compare performance with operating plans and standards and to report and
interpret the results of operations to all levels of management and to the owners
of business. This function includes the formulation and administration of
accounting policy and the compilation of statistical records and special reports as
iii. To consult with all segments of management responsible for policy or action
concerning any phase of the operations of business as it relates to the attainment
of objectives and the effectiveness of policies, organization structure and
iv. To administer tax policies and procedures.
v. To supervise and coordinate the preparation of reports to governmental
vi. To assure fiscal protection to the assets of the business through adequate
internal control and proper insurance coverage.
vii. To continuously appraise economic and social forces and government influences
and interpret their effect on business.

The controllers’ Institute, as well as the National Industrial conference Board of the
United States, have spelt out the functions of the controller in still greater detail but the
seven-point concept of modern controllership is board enough to leave no phase of
policy or organization beyond the controller’s jurisdiction. Through the concept has been
laid down mainly from the functional point of view, it lifts the notion of controllership from
pedestrian paper-shuffling to a top-management attitude that aids decision – making, it
broadens controller’s outlook and provides him with specific goals.

Status of Controller:
There is no fixed place for the controller in the hierarchy of management. It is
sometimes said that the status of controller is not ensured simply by virtue of his holding
the office but depends, in no small measure, upon hi personality, mental equipment,
industrial background and his capacity to convince others of his ability as well as
integrity. Moreover, it would depend upon the terms of his appointment and, therefore, it
is bound to vary with every individual undertaking. The terms of appointment may be
fixed by the Board of Directors or may be included in the Articles of Association of the

As a matter of general principle, all accounting functions, even though remotely

connected with finance, are included in the responsibilities of the controller. As the chief
accounting authority, the controller normally has his place in the top-level management
along with the Treasurer who looks after bank accounts and the safe custody of liquid
assets. Usually, the elevation of Controller to the post of Vice-President Finance in
taken for granted and is considered only a routine matter.

Modern Controller does not do any controlling, as is commonly understood, in terms of

line authority over other departments, his decision regarding the best accounting
procedures to be followed by line people are transmitted to the Chief Executive who
communicates them by a manual of instructions coming down through line chain of
command to all people affected by the procedures.

It is also necessary that the limitation of Controller’s role imposed by the very nature of
his work, must be borne in mind. Though the Controller helps in bringing together all
phases of management, he does not pretend to solve the problems of production of
marketing, he knows their nature and so can discuss in detail with all levels of
management the financial implications of solutions they suggest.
According to the American Institute of Certified Public Accountants, “Financial
statements reflect a combination of recorded facts accounting conventions and personal
judgements and the judgements and conventions applied affect them materially.” This
statement makes clear that the accounting information as depicted by the financial
statements are influenced by three factors viz. recorded facts, accounting conventions
and personal judgements.


1. To provide reliable information about economic resources and obligations of a
business and other needed information about changes in such resources or
2. To provide reliable information about changes in net resource [resources less
obligations] arising out of business activities and financial information that assits
in estimating the earning potentials of business.
3. To disclose to the extent possible, other information related to the financial
statements that is relevant to the needs of the users of these statements.


Different classes of people are interested in the financial statement analysis with a view
to assessing the economic and financial position of any business or industrial concern in
terms of profitability, liquidity or solvency. Such persons and bodies include:

1. Shareholders
2. Debenture-holders
3. Creditors
4. Financial institutions and commercial banks
5. Prospective investors
6. Employees and trade unions
7. Tax authorities
8. Govt. departments
9. The company law board
10. Economists and investment analysis, etc.

Financial statements help the management to understand the position, progress and
prospects of business results. By providing the management with the causes of
business results, they enable them to formulate appropriate policies and courses of
actions for the future. The management communicate only through these financial
statements their performance to various parties and justify their activities and thereby
their existence.


These statements enable the shareholders to know about the efficiency and
effectiveness of the management and also the earning capacity and the financial
strength of the company.

The financial statements serve as a useful guide for the present suppliers and probable
lenders of a company. It is through a critical examination of the financial statements that
these groups can come to know about the liquidity profitability and long-term solvency
position of a company. This would help them to decide about their future course of

Workers are entitled to bonus depending upon the size of profit as disclosed by audited
profit and loss account. Thus, P & L a/c becomes greatly important to the workers in
wage negotiations also the size of profits and profitability achieved are greatly relevant.

Business is a social entity. Various groups of the society, though not directly connected
with business, are interested in knowing the position, progress and prospects of a
business enterprise. They are financial analysts, lawyers, trade associations, trade
unions, financial press research scholars, and teachers, etc.

Importance of National Economy: The rise & growth of the corporate sector, to a
great extent, influences the economic progress of a country. Unscrupulous & fraudulent
corporate managements shatters the confidence of the general public in joint stock
companies which is essential for economic progress & retard economic growth of the
country. Financial Statements come to rescue of general public by providing information
by which they can examine & asses the real worth of the company & avoid being
cheated by unscrupulous persons.

Limitations of Financial Statements:

1. It shows only historical cost.

2. It does not take into account the price level changes.
3. It considers only monetary aspects but does not consider some vital non-
monetary factors.
4. It is based on convention and judgement. Hence there is no accuracy.
5. Comparison of Financial Statements depends upon the uniformity of Accounting
6. It is subject to window dressing.

Financial Statement are indicators of the two significant factors:

(i) Profitability, and (ii) Financial soundness

Analysis and interpretation of financial statements, therefore, refer to such a treatment

of the information contained in the income statement and the Balance Sheet so as to
afford full diagnosis of the profitability and financial soundless of the business.


Financial Analysis can be classified into different categories depending upon

(i) The materials used and (ii) The modus operandi of analysis

ON THE BASIS OF MATERIAL USED: According to this basis financial analysis can
be of two types.

(i) External Analysis: This analysis is done by those who are outsiders for the
business. The term outsiders includes investors, credit agencies, government and other
creditors who have no access to the internal records of the company.

(ii) Internal Analysis: This analysis is done by persons who have access to the books
of account and other information related to the business.

On the basis of modus operandi. According to this, financial analysis can also be two

(i) Horizontal analysis: In case of this type of analysis, financial statements for a
number of years are reviewed and analyzed. The current year’s figures are compared
with the standard or base year. The analysis statement usually contains figures for two
or more years and the changes are shown recording each item from the base year
usually in the from of percentage. Such an analysis gives the management considerable
insight into levels and areas of strength and weakness. Since this type of analysis is
based on the data from year to year rather than on the date, it is also termed as
Dynamic Analysis.

(ii) Vertical analysis: In case of this type of analysis a study is made of the quantitative
relationship of the various terms in the financial statements on a particular date. For
example, the ratios of different items of costs for a particular period may be calculated
with the sales for that period such an analysis is useful in comparing the performance of
several companies in the same group, or divisions or departments in the same


A financial analyst can adopt one or more of the following techniques/tools of financial

1. Comparative Financial Statements: Comparative financial statements are

those statements which have been designed in a way so as to provide time
perspective to the consideration of various elements of financial position
embodied in such statements. In these statements figures for two or more
periods are placed side by side to facilitate comparison.
Both the income statement and Balance Sheet can be prepared in the form of
Comparative Financial Statements.

Comparative Income Statement: The Income statement discloses net profit or Net
Loss on account of operations. A comparative Income Statement will show the absolute
figures for two or more periods, the absolute change from one period to another and if
desired the change in terms of percentages. Since, the figures for two or more period
are shown side by side, the reader can quickly ascertain whether sales have increased
or decreased, whether cost of sales has increased or decreased etc. Thus, only a
reading of data included in Comparative Income Statements will be helpful in deriving
meaningful conclusions.

Comparative Balance Sheet: Comparative Balance Sheet as on two or more different

dates can be used for comparing assets and liabilities and finding out any increase or
decrease in those items. Thus, while in a single Balance Sheet the emphasis is on
persent position, it is on change in the comparative Balance Sheet. Such a Balance
sheet is very useful in studying the trends in an enterprise.
The preparation of comparative financial statements can be well understood with the
help of the following illustration.

ILLUSTRATION : From the following Profit and Loss Accounts and the Balance Sheet
of Swadeshi polytex Ltd. For the year ended 31st December, 1987 and 1988, you are
required to prepare a comparative Income Statement and Comparative Balance Sheet.


(In Lakhs of Rs.)
Particular 1987 1988 *Assets 1987 1988
Rs. Rs. Rs. Rs.
To Cost of Goods sold 600 750 By Net 800 1,000
To operating Expenses
Administrative Expenses 20 20
Selling Expenses 30 40
To Net Profit 150 190
800 1,000 800 1,000
(In Lakhs of Rs.)
Liabilities 1987 1988 Assets 1987 1988
Rs. Rs. Rs. Rs.
Bills Payable 50 75 Cash 100 140

Sundry Creditors 150 200 Debtors 200 300

Tax Payable 6% 100 150 Stock 200 300

Debentures 6% 100 150 Land 100 100
Preference 300 300 Building 300 270

Equity Capital 400 400 Plant 300 270

Reserves 200 245 Furniture 100 140

1300 1520 1300 1520
Swadeshi Polytex Limited
(In Lakhs of Rs.)
Absolute Percentage
increase or increase or
decrease in decrease in
1988 1988
1987 1988
Net Sales 800 1000 +200 +25
Cost of Goods 600 750 +150 +25
Gross Profit 200 350 +50 +25
Operating 20 20 - -
Selling 30 40 +10 +33.33
Total Operating 50 60 10 +20
Operating Profit 150 190 +40 +26.67
Swadeshi Polytex Limited
AS ON 31ST DECEMBER, 1987, 1988
Figures in lakhs of rupees
Assets 1987 1988 Absolute Percentage
increase or increase (+)
decrease or decrease
during 1988 (-) during
Current Assets:
Cash 100 140 40 +40
Debtors 200 300 100 +50
Stock 200 300 100 +50
Total Current Assets 500 740 240 +50
Fixed Assets:
Land 100 100 - -
Building 300 270 -30 -10%
Plant 300 270 -30 -10%
Furniture 100 140 +40 +40%
Total Fixed Assets 800 780 -20 -2.5%
Total Assets 1300 1520 220 +17%
Liabilities &
Current Liabilities
Bills Payable 50 75 +25 +50%
Sundry Creditors 150 200 +50 +33.33%
Tax Payable 100 150 +50 +50%
Total Current 300 425 +125 +41.66%
Long-term Liabilities : 100 150 +50 +50%
Total Liabilities 400 575 +175 +43.75%
Capital & Reserves
6% Pre. Capital 300 300 - -
Equity Capital 400 400 - -
Reserves 200 245 45 22.5
Total Shareholders’ 900 945 45 5%
Total Liabilities and 1300 1520 220 17%

2. Common – size Financial Statements: Common – size Financial Statements are

those in which figures reported are converted into percentages to some common
base. In the Income Statement that sale figure is assumed to be 100 and all
figures are expressed as a percentage of this total.

Illustration: Prepare a Common – size Income Statement & Common-size Balance

Sheet of Swadeshi Polytex Ltd., for the years ended 31st December, 1987 & 1988

Swadeshi Polytex Limited
(Figures in Percentage)
1987 1988
Net Sales 100 100
Cost of Goods Sold 75 75
Gross Profit 25 25
Opening Expenses:
Administration Expenses 2.50 2
Selling Expenses 3.75 4
Total Operating Expenses 6.25 6
Operating Profit 18.75 19

Interpretation: The above statement shows that though in absolute terms, the cost of
goods sold has gone up, the percentage of its cost to sales remains constant at 75%,
this is the reason why the Gross Profit continues at 25% of sales. Similarly, in absolute
terms the amount of administration expenses remains the same but as a percentage to
sales it has come down by 5%. Selling expenses have increased by 25%. This all leads
to net increase in net profit by 25% (i.e., from 18.75% to 19%)
3. Trend Percentage: Trend Percentages are immensely helpful in making a
comparative study of the Financial statements for several years. The
method of calculating trend percentages involves the calculation of
percentage relationship that each item bears to the same item in the base
year. Any year may be taken as base year. It is usually the earliest year.
Any intervening year may also be taken as the base year. Each item of
base year is taken as 100 and on that basis the percentages for each of
the years are calculated. These percentages can also be taken as Index
Numbers showing relative changes in the financial data resulting with the
passage of time.
The method of trend percentages is useful analytical device for the management
since by substitution percentages for large amounts, the brevity and readability
are achieved. However, trend percentages are not calculated for all of the items
in the financial statements. They are usually calculated only for major items since
the purpose is to highlight important changes.
Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis are the
other tools of Financial Analysis which have been discussed in detail as separate

Meaning and Nature of ratio analysis

The term “ratio” simply means one number expressed in terms of another. It describes
in mathematical terms the quantitative relationship that exists between two numbers,
the terms “accounting ratio”. J. Batty points out, is used to describe significant
relationships between figures shown on a Balance Sheet, in a Profit and Loss Account,
in a Budgetary control System or in any other Part of the accounting organisation. Ratio
Analysis, simply defined, refers to the analysis and interpretation of financial statements
through ratios. Nowadays it is used by all business and industrial concerns in their
financial analysis. Ratio are considered to be the best guides for the efficient execution
of basic managerial functions like planning, forecasting, control etc.

Ratios are designed to show how one number is related to another. It is worked out by
dividing one number by another. Ratios are customarily presented either in the form of a
coefficient or a percentage or as a proportion. For example, the current Assets and
current Liabilities of a business on a particular date are Rs. 2.5 Lakhs and Rs. 1.25
lakhs respectively. The resulting ratio of current Assets and current Liabilities could be
expressed as (i.e. Rs. 2,00,000/1,25,000) or as 200 per cent. Alternatively in the form of
a proportion the same ratio may be expressed as 2:1, i.e. the current assets are two
times the current liabilities.

Ratios are invaluable aids to management and others who are interested in the analysis
and interpretation of financial statements. Absolute figures may be misleading unless
compared, one with another. Ratios provide the means of showing the relationship
which exists between figures. Though there is no special magic in ratio analysis, many
prefer to base conclusions on ratios as they find them highly useful for making
judgments more easily. However, the numerical relationships of the kind expressed by
ratio analysis are not an end in themselves, but are a means for understanding the
financial position of a business. Generally, simple ratios or ratios compiled from a single
year financial statements of a business concern may not serve the real purpose. Hence,
ratios are to be worked out from the financial statements of a number of years.

Ratios, by themselves, are meaningless. They derive their status partly from the
ingenuity and experience of the analyst who uses the available data in a systematic
manner. Besides, in order to reach valid conclusions, ratios have to be compared with
some standards that are established with a view to represent the financial position of
the business under review. However, it should be borne in mind that after computing the
ratios one cannot categorically say whether a particular ratio is god or bad as the
conclusions may vary from business to business. A single ideal ratio cannot be applied
for all types of business. Speedy compiling of ratios and their presentations in the
appropriate manner are essential. A complete record of ratios employed in advisable
and explanation of each, and actual ratios year by year should be included. This record
may be treated as a part of an Accounts Manual or a special Ratio Register may be

Ratios can be classified into different categories depending upon the basis of

The traditional classification has been on the basis of the financial statement to which
the determinants of a ratio belong. On this basis of ratios could be classified as:

1. Profit and loss Accounts Ratios, i.e. ratios calculated on the basis of the items of
the Profit and Loss account only e.g. Gross Profit ratio, stock turnover ratio, etc.
2. Balance sheet ratios, i.e., ratio calculated on the basis of figures of Balance
sheet only, e.g., current ratio, debt-equity etc.
3. Composite ratios or inter-statements ratios, i.e., ratio on figures of profit and loss
account as well as the balance sheet, e.g. fixed assets turnover ratio, overall
profitability ratio etc.

However, the above basis of classification has been found to be guide and unsuitable
because analysis of Balance sheet and Balance sheet and income statement can not
be done in insalaion. The have to be studied together in order to determine the
profitability and solvency of the business. In order that ratios serve as a toll for financial
analysis, they are now classified as:

(1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financial ratios,
(a) Liquidity Ratios (b) Stability Ratios.

Profitability is an indication of the efficiency with which the operations of the business
are carried on. Poor operational performance may indicate poor sales and hence poor
profits. A lower profitability may arise due to the lack of control over the expenses.
Bankers, financial institutions and other creditors look at the profitability ratios indicator
whether or not the firm earns substantially more than it pays interest for the use of
borrowed funds and whether the ultimate repayment of their debt appears reasonably
certain. Owners are interested to know the profitability as it indicates the return which
they can on their investments. The following are the important profitability ratios:


It is also called “Return on investment” (ROI) or Return On Capital Employed (ROCE) it
indicates the percentage of return on the total capital employed in the business. It is
calculated on the basis of the following formula.

Operation Profit x 100

Capital employed

The term capital employed has been given different meanings by different accountants.
Some of the popular meanings are as follows:

i) Sum-total of all assets whether fixed or current

ii) Sum-total of fixed assets
iii) Sum-total of long-term funds employed in the business, i.e.,

Share capital + Reserves & Surplus + Long Term loans + Non business assets +
Fictitious assets.

In Management accounting, the term capital employed is generally used in the meaning
given in the third point above.

The term “Operating profit” means “Profit before Interest & Tax.” The term “Interested”
means “Interested on long term borrowing”. Interest on short – term borrowings will be
deducted for computing operating profit. Non-term borrowing will be deducted for
computing operating profit. Non-trading incomes such as interested on Government
securities or non-trading losses or expenses such as loss on account of fire, etc., will
also be excluded.

2. Return on Shareholders “Funds”: In case it is desired to work out the

profitability of the company from the shareholders point of view, it should be
computed as follows:

Net Profit after interest & tax

---------------------------------------- x 100
Shareholders’ Funds

The term Net Profit here means “Net Incomes after Interest & Tax” It is different from
the “Net Operating Profit” Which is used for computing the “Return on Total Capital
Employed” in the business. This because the shareholders are interested in Total
Income after Tax including Net Non-operating Income (i.e., Non-operating Income –
Non-operating Expenses)

3. Fixed dividend Cover: This ratio is important for preference shareholders

entitled to get dividend at a fixed rate in priority to other shareholders. The ratio is
calculated as follows:

Net Profit after Interest & tax

Fixed dividend cover = -------------------------------------------------
Preference dividend

4. Debt service coverage ratio: The interest coverage ratio, as explained above,
does not tell us anything about the ability of a company to make payment of
principle amounts also on time. For this purpose debt service coverage ratio is
calculated as follows:
Net Profit before interest & tax
Debt service coverage ratio = ---------------------------------------------------
Principal Payment Instalment
Interest + -----------------------------------------
1 – (Tax rate)

The principle payment instalment is adjusted for tax effects since such payment is not
deductible from net profit for tax purposes.
Net Profit Before Interest & Tax
5. Interest Coverage Ratio = -------------------------------------------------------
Interest Charges

Gross Profit
6. Gross Profit Ratio = ------------------------------------------------- x 100
Net Sales

Net Profit
7. Net Profit Ratio = ------------------------------------------------ x 100
Net Sales

Operating Profit
Operating Profit Ratio = -------------------------------------------- x 100
Net Sales

Operating Profit = Net Profit + Non-Operating expenses – Non – operating income

Operating Cost
9. Operating Ratio = --------------------------------- x 100
Net Sales

Amount available to Equity Shareholders

10. Earnings Per Share (EPS) = ------------------------------------------------------------
Number of Equity Shares

Market Price per Share

11. Price – Earnings (P/E) Ratio = -------------------------------------------
Earning Per Share

1. Fixed assets turnover ratio : This ratio indicates the extent to which the
investments in fixed assets contribute towards sales. If compares with a previous
period, it indicates whether the investment in fixed assets has been judicious or
not. The ratio is calculated as follows:

Net Sales
Fixed Assets (NET)

2. Working Capital Turnover Ratio: This is also known as Working Capital

Leverage Ratio. This ratio indicates whether or net working capital has been
utilized in making sales. In case a company can achieve higher volume of sales
with relatively small amount of working capital, it is an indication of the operating
efficiency of the company. The ratio is calculated as follows.

Net Sales
Working Capital

Working capital turnover ratio may take different forms for different purposes. Some of
them are being explained below:

(i) Debtors” turnover ratio (Debtors, Velocity): Debtors constitute an important

constituent of current assets and therefore the quality of debtors to a great extent
determines a firm’s liquidity. Two ratios are used by financial analysis to judge the
liquidity of a firm. They are (i) Debtor’s turnover ratio, and (ii) Debt collection period

The Debtor’s turnover ratio is calculated as under:

Credit sales
Average accounts receivable

The term Accounts Receivable include “Trade Debtors” and Bill Receivable”.

In case details regarding and closing receivable and credit sales are not available the
ratio may be calculated as follows:

Total Sales
Accounts Receivable

Significance: Sales to Accounts Receivable Ratio indicates the efficiency of the staff
entrusted with collection of book debts. The higher the ratio, the better it is, Since it
Would indicate that debts are being collected more promptly. For measuring the
efficiency, it is necessary to set up a standard figure, a ratio lower then the standard will
indicate inefficiency.

The ratio helps in Cash Budgeting, since the flow of cash form customers can be
worked out on the basis of sales.

(ii) Debt collection Period ratio: The ratio indicates the extent to which the debts have
been collected in time. It gives the average debt collection period. The ratio is very
helpful to the lenders because it explains to them whether their borrowers are collecting
money within a reasonable time. An increase in the period will result in greater blockage
of funds in debtors. The ratio may be calculated by any of the following methods.

Months (or days) in a year

(a) ----------------------------------------------------
Debtors’ turnover

Average Accounts Receivable x Months (or days) in a year

(b) --------------------------------------------------------------------------------------
Credit sales for the year

Accounts receivable
(c) -------------------------------------------------------------------
Average monthly or daily credit sales

In fact, the two ratios are interrelated Debtor’s turnover ratio can be obtained by dividing
the months (or days)

In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the number
of months (or days) in a year are divided by the debtors turnover, average debt
collection period is obtained (i.e., 12/6 – 2 months)

Significance: Debtors’ collection period measures the quality of debtors since it

measures the rapidity or slowness with which money is collected from them. A short
collection period implied prompt payment by debtors. It reduces the chances of bad

A longer collection period implies too liberal and inefficient credit collection
performance. However, in order to measure a firm’s credit and collection efficiency its
average collection period should be compared with the average of the industry. It should
be neither too liberal nor too restrictive. A restrictive policy will result in lower sales
which will reduce profits.

It is difficult to provide a standard collection period of debtors. It depends upon the

nature of the industry, seasonable character of the business and credit policies of the
firm. In general, the amount of receivables should not exceed a 3-4 months’ credit

(iii) Creditors’ turnover ratio (Creditors’ velocity): It is similar to debtors ‘Turnover

Ratio. It indicates the speed with which the payment for credit purchases are made to
the creditors. The ratio can be computed as follows:

Credit Purchases
Average accounts payable

The term Accounts payable include “Trade Creditors” and “Bills payable”

In case the details regarding credit purchases, opening closing accounts payable have
not been given, the ratio may be calculated as follows:

Total Purchases
Account Payable

(iv) Debt payment period enjoyed ratio (Average age of payable):

The ratio give the average credit period enjoyed from the creditors. It can be computed
by any one of the following methods:
Month’s or days in a year
(a) ---------------------------------------------------
Creditors’ turnover

Average accounts payable x Months (or days) in a year

(b) ----------------------------------------------------------------------------------------
Credit purchases in the year

Average accounts payable

(c) -------------------------------------------------------------------------
Average monthly (or daily) credit purchases

Significance: Both the creditors turnover ratio and the debt payment period enjoyed
ratio indicate about the promptness or otherwise in making payment of credit
purchases. A higher “creditors turnover ratio” or a “lower credit period enjoyed ratio”.
Signifies that the creditors are being paid promptly, thus enhancing the credit
worthiness of company. However, a very favourable ratio to this effects also shows that
the business is not taking full advantage of credit facilities which can be allowed by the

Stock Turnover Ratio: This ratio indicate whether investments in inventory is efficiently
used or not. It therefore, explains whether investment in inventories is within proper
limits or not. The ratio is calculated as follows:

Cost of goods sold during the year

Average inventory

Average inventory is calculated by taking stock levels of raw materials work – in –

process, finished goods at the end of each months, adding them up and dividing by

Inventory ratio can be calculated regarding each constituent of inventory. It may thus be
calculated regarding raw materials, Work in progress & finished goods.
Cost of goods sold
1* --------------------------------------------------
Average stock of finished goods

Materials consumed
2** ----------------------------------------------
Average stock of raw materials

Cost of completed work

3*** ------------------------------------------
Average work in progress

The method discussed above is as a matter of fact the best basis for computing the
stock Turnover Ratio. However, in the absence of complete information, the inventory
Turnover Ratio may also be computed on the following basis.

Net sales
Average inventory at selling Prices

The average inventory may also be calculated on the basis of the average of inventory
at the beginning and at the end of the accounting period.

Inventory at the beginning of the accounting period + Inventory at

the end of the accounting period
Average Inventory = --------------------------------------------------------------------------------------

Significance: As already stated, the inventory turnover ratio signifies the liquidity of the
inventory. A high inventory turnover ratio indicates brisk sales. The ratio is, therefore, a
measure to discover the possible trouble in the form of overstocking or overvaluation.
The stock position is known as the graveyard of the balance sheet. If the sales are quick
such as a position would not arise unless the stocks consists of unsalable items. A low
inventory turnover ratio results in blocking of funds in inventory becoming obsolete or
deteriorating in quality.

It is difficult to establish a standard ratio of inventory because it will differ from industry.
However, the following general guidelines can be given.
(i) The raw materials should not exceed 2-4 months’ consumption of the year.
(ii) The finished goods should not exceed 2-3 months’ sales
(iii) Work in progress should not exceed 15-30 days’ cost of sales.

PRECAUTIONS: While using the Inventory Ratio, care must be taken regarding the
following factors:

(i) Seasonable conditions: If the balance sheet is prepared at the time of slack
season, the average inventory will be much less (if calculated on the basis of inventory
at the beginning of the accounting period & inventory at close of the accounting period).
This may give a very high turnover ratio.

(ii) Supply conditions: In case of conditions of security inventory may have to be kept
in high quality for meeting the future requirements.

(iii) Price trends: In case of possibility of a rise in prices, a large inventory may be kept
by business. Reverse will be the case if there is a possibility of fall in prices.

(iv) Trend of volume of business: In case there is a trend of sales being sufficiently
higher than sales in the past, a higher amount of inventory may be kept.

Financial Ratios indicate about the financial position of the company. Accompany is
deemed to be financially sound if it is in a position to carry on its business smoothly and
meetits obligions, both short – term as well as longterm, without strain. It is a sound
principle of finance that the short-term requirements of funds should be met out of short
term funds and long-term requirements should be met out of long-term funds. For
example if the payment for raw materials purchases are made through the issue
debentures it will create a permanent interest burden on the enterprise. Similarly, if fixed
assets are purchased out of funds provide by bank overdraft, the firm will come to grief
because such assets cannot be sold away when payment will be demanded by the

Financial ratios can be divided into two broad categories:

(1) Liquidity Ratios & (2) Stability Ratios

(1) LIQUIDITY RATIOS: These ratios are termed as “working capital” or “short-term
solvency ratios”. As enterprise must have adequate working-capital to run its day-to-day
operations. Inadequacy of working capital may bring the entire business operation to a
grinding halt because of inability of enterprise to pay for wages, materials & other
regular expenses.

CURRENT RATIOS: This ratio is an indicator of the firm’s commitment to meet its
short-term liabilities. It is expressed as follows:

Current assets
Current Liabilities

Current assets mean assets that will either be used up or converted into cash within a
year’s of time or normal operating cycle of the business, whichever is longer. Current
liabilities means liabilities payable within a year or operating cycle, whichever is longer,
out of existing current assets or by creation of current liabilities. A list of items include in
current assets & current liabilities has already been given in the performs analysis
balance sheet in the preceding chapter.

Book debts outstanding for more than six months & loose tools should not be included
in current assets. Prepaid expenses should be taken as current assets.

An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency due
to the fact that if the current assets are reduced to half, i.e., 1 instead of 2, then also the
creditors will be able to get their payments in full. However a business having seasonal
trading activity may show a lower current ratio at a creation period of the year. A very
high current ratio is also not desirable since it means less efficient use of funds. This is
because a high current ratio means excessive dependence on long-term sources of
raising funds. Long-term liabilities are costlier than current liabilities & therefore, this will
result in considerably lowering down the profitability of the concern.

It is to be noted that the mere fact current ratio is quite high does not mean that the
company will be in position to meet adequately its short-term liabilities. In fact, the
current ratio should be seen in relation to the component of current assets & liquidity. If
a large portion of the current assets comprise obsolete stocks or debtors outstanding for
a long term, time, the company may fail even if the current ratio is higher then 2.

The current ratio can also be manipulated very easily. This may be done either by either
postponing certain pressing payments or postponing purchase of inventories or making
payment of certain current liabilities.

Significance: The current ratio is an index of the concern’s Financial stability since it
shows the extent of working capital which is the amount by which the current assets
exceed the current liabilities. As stated earlier, a higher current ratio would indicate
inadequate employment of funds while a poor current ratio is a danger signal to the
management. It shows that business is trading beyond its resources.

(II) QUICK RATIO: This ratio is also termed as “acid test ratio” or “liquidity ratio”. This
ratio is ascertained by comparing the liquid assets (i.e., assets which are immediately
convertible into cash without much loss) to current liabilities prepaid expenses and stock
are not taken as liquid assets. The ratio may be expressed as:

Liquid assets
Current liabilities

Some accountants prefer the term “Liquid Liabilities” for “Current Liabilities” or the
purpose of ascertaining this ratio. Liquid liabilities means liabilities which are payable
within a short period. The bank over-draft (if it becomes a permenant mode of financing)
& cash credit faculties will be excluded from current liabilities in such a case.
The ideal ratio is 1.

This ratio is also an indicator of short-term solvency of the company.

A comparison of the current ratio to quick ratio shall indicate the inventory hold-ups. For
example if two units have the same current ratio but different liquidity ratio, it indicates
over-stocking by the concern having low liquidity ratio as compared to the concern
which has a higher liquidity ratio.

Thus, debtors are excluded from liquid assets for the purpose of comparing super –
quick ratio. Current liabilities & liquid liabilities have the same meaning as explained
above. The ratio is the more measure of firms’ liquidity position. However, it is not
widely used in practice.

STABILITY RATIO: These ratios help in ascertaining long term solvency of a firm which
depends basically on three factors:

(i) Whether the firm has adequate resources to meet its long term funds requirements.

(ii) Whether the firm has used an appropriate debt-equity mix to raise long-term funds.

(iii) Whether the firm earns enough to pay interest & instalment of long-term loans in

The capacity of the firm to meet the last requirement can be ascertained by computing
the various coverage ratios, already explained in the preceding pages. For the other two
requirements, the following ratios can be calculated.

(1) FIXED ASSETS RATIO: This ratio explains whether the firm has raised adequate
long-term funds to meet its fixed assets requirements. It is expressed as follows:

Fixed assets
Long – Term funds

The ratio should not be more than 1. If it is less than 1, it shows that a part of the
working capital has been financed through long-term funds. This is desiarable to some
extent because a part of working capital termed as “Core Working Capital” is more or
less is a fixed nature. The ideal ratio is 67.

(ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capital structure of
firm is made up or the debt-equity mix adopted by the firm. The following ratios fall in
the category.

(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportion
between fixed interest or dividend bearing funds & non-fixed interest or dividend bearing
funds in the total capacity employed in the business. The fixed interest or dividend
bearing funds include the funds provided by the debenture holders & preference
shareholders. Non-fixed interest or dividend bearing funds are the funds provided by the
equity shareholders. The amount, therefore, includes the Equity Share Capital & other
Reserves. A proper proportion between the two funds is necessary in order to keep the
cost of capital at the minimum.

The capital gearing ratio can be ascertained as follows:

Funds bearing fixed interest or fixed dividend

Equity Shareholder’s Funds

(b) DEBT-EQUITY RATIO: The debt-equity ratio is determined to ascertain the

soundness of the long-term financial position of the company. It is also known as
“External – Internal” equity ratio.

Total long-term debt

Debt – Equity Ratio = ------------------------------------------
Shareholder’s funds

Significance: The ratio indicates the preparation of owners’ stake in the business.
Excessive liabilities tend to cause insolvency. The ratio indicates the extent to which the
firm depends upon outsiders for its existence. The ratio provides a margin of safety to
the creditors. It tells the owners the extent to which they can gain the benefits or
maintain control with a limited investment.

(c) Proprietary ratio : It is a variant of debt-equity ratio. It establishes relationship

between the proprietor’s funds & the total tangible assets. It may be expressed as:
Shareholder’s funds
= --------------------------------
Total tangible assets

Significance: This ratio focuses the attention on the general financial strength of the
business enterprise. The ratio is of particular importance to the creditors who can find
out the proportion of shareholders funds in the total assets employed in the business. A
high proprietary ratio will indicate a relatively little danger to the creditor’s etc., in the
event of forced reorganization or winding up of the company. A low proprietary ratio
indicates greater risk to the creditors since in the event of losses a part of their money
may be lost besides loss to the properties of the business. The higher the rate, the
better it is. A ratio below 50 percent may be alarming for the creditors since they may
have to lose heavily in the event of company’s liquidation on account of heavy losses.


Following are some of the advantages of ratio analysis:

1. Simplifies financial statements: Ratio Analysis simplified the comprehension of

financial statements. Ratios tell the whole story of changes the financial condition
of the business.
2. Facilitates inter-firm comparison: Ratio Analysis provides date for inter-firm
comparison. Ratios highlight the factors associated with successful &
unsuccessful firms. They also reveal strong firms & weak firms, over-valued &
under valued firms.
3. Makes intra-firm comparision possible: Ratio Analysis also makes possible
comparision of the performance of the different divisions of the firm. The ratios
are helpful in deciding about their efficiency or otherwise in the past & likely
performance in the future.
4. Helps in planning: Ratio Analysis helps in planning & forecasting. Over a period
of time a firm or industry develops certain norms that may indicate future success
or failure. If relationship changes in firms data over different time periods, the
ratios may provide clues on trends and future problems.

Thus “Ratio can assist management in its basic functions of forecasting planning
coordination, control and communication”.


1. Comparative study required: Ratios are useful in judging the efficiency of the
business only when they are compared with the past results of the business or
with the results of a similar business. However, such a comparision only provides
a glimpse of the past performance and forecasts for future may not be correct
since several other factors like market conditions, management policies, etc. may
affect the future operations.
2. Limitations of financial statements: Ratios are based only on the information
which has been recorded in the financial statements which suffer from a number
of limitations.

For example non-financial charges though important for the business are not revealed
by the financial statements. If the management of the company changes, it may have
adverse effect on the future profitability of the company but this cannot be judged by
having a glance at the financial statements of the company.

Financial statements show only historical cost but not market value.

The comparision of one firm with another on the basis of ratio analysis without taking
into account the fact of companies having different accounting policies will be
misleading and meaningless.

3. Ratios alone are not adequate : Ratios are only indicators they cannot be taken
as final regarding good or bad financial position of the business Other things
have also to be seen.
4. Window dressing: The term window dressing means manipulations of accounts
in a way so as to conceal vital facts and present the financial statements in a way
to show a better position than what it actually is. On account of such a situation
presence of a particular ratio may not be a definite indicator of good or bad
5. Problem of price level changes: Financial analysis based on accounting ratios
will give misleading results if the effects of changes in price level are not taken
into account.
6. No fixed standards: No fixed standards can be laid down for ideal ratios. For
example, current ratio is generally considered to be ideal if current assets are
twice the current liabilities. However, in case of these concerns which have
adequate arrangements with their bankers for providing funds when they require,
it may be perfectly ideal if current assets are equal to slightly more than current
7. Ratios area composite of many figures: Ratios are a composite of many
different figures. Some cover a time period, others are at an instant of time while
still others are only averages. A balance sheet figures shows the balance of the
account at one moment of one day. It certainly may not be representative of
typical balance during the year. It may, therefore, be conducted that ratio
analysis, if done mechanically, is not only misleading but also dangerous.

The computation of different accounting ratios & the analysis of the financial statements
on their basis can be very well understood with the help of the illustrations given in the
following pages:


Illustration 1: Following is the Profit and Loss Account and Balance Sheet of Jai Hind
Ltd., Redraft the for the purpose of analysis and calculate the following ratios:

i. Gross Profit Ratios

ii. Overall Profitability Ratio
iii. Current Ratio
iv. Debt-Equity Ratio
v. Stock Turnover Ratios
vi. Liquidity Ratios


Db. Cr.
Opening stock of finished 1,00,000 Sales 10,00,000
Opening stock of raw 50,000 Closing stock of raw 1,50,000
materials materials
Purchase of raw materials 3,00,000 Closing stock of finished 1,00,000
Direct wages 2,00,000 Profit on sale of shares 50,000

Manufacturing expenses 1,00,000

Administration expenses 50,000
Selling & Distribution 50,000
Loss on sale of plant 55,000
Interest on Debentures 10,000
Net Profit 3,85,000

13,00,000 13,00,000

Liabilities Rs. Assets Rs.
Share Capital: Fixed Assets 2,50,000
Equity Share Capital 1,00,000 Stock of raw materials 1,50,000
Preference share capital 1,00,000
Reserves 1,00,000 Stock of finished 1,00,000
Debentures 2,00,000 Sundry debtors 1,00,000
Sundry Creditors 1,00,000 Bank Balance 50,000
Bills Payable 50,000

6,50,000 6,50,000

Sales Rs. 10,00,000

Less: Cost of sales

Raw material consumed (op. Stock + Purchases – 2,00,000
Closing Stock)
Direct Wages 2,00,000
Manufacturing expenses 1,00,000
Cost of production 5,00,000
Add: Opening stock of finished goods 1,00,000
Less: Closing stock of finished goods. Cost of goods 1,00,000 5,00,000
Gross Profit 5,00,000
Less: Operating Expenses:
Administration expenses 50,000
Selling and distribution expenses 50,000 1,00,000
Net operating profit 4,00,000
Add: Non-trading income: 50,000
Profit on sale of shares 4,50,000

Less: Non-trading expenses or losses:

Loss on sale of plant 55,000
Income before interest & tax 3,95,000
Less: Interest on debentures 10,000
Net Profit before tax 3,85,000


Bank balance 50,000
Sundry debtors 1,00,000
Liquid assets 1,50,000
Stock of raw materials 1,50,000
Stock of finished goods 1,00,000
Current assets 4,00,000
Sundry creditors 1,00,000
Bills Payable 50,000
Current liabilities 1,50,000
Working Capital (Rs. 4,00,000 – Rs. 1,50,000) 2,50,000
Add Fixed assets 2,50,000
Capital employed 5,00,000
Less Debentures 2,00,000
Shareholders’ net worth 3,00,000
Less Preference share capital 1,00,000
Equity shareholders’ net worth 2,00,000
Equity shareholders’ net worth is represented by: 1,00,000
Equity Share capital 1,00,000
Reserves 2,00,000

Gross Profit x 100 50,000 x 100
(i) Gross Profit Ratio ---------------------------- -------------------------- = 50%
Sales 10,00,000

Operating Profit x 100 4,00,000 x 100

(ii) Overall Profitability Ratio = ------------------------------- = --------------------- = 80%
Capital employed 5,00,000

Current assets 4,00,000

(iii) Current Ratio = ------------------------------- = -------------------------- = 2.67
Current liabilities 1,50,000

External equities 3,50,000

(iv) Debt Equity Ratio: = -------------------------- = --------------------- = 1.17
Internal equities 3,00,000


Total long- term debt 2,00,000

------------------------------ = ----------------- = 0.40
Total long-term funds 5,00,000


Total long-term debt 2,0,00,000

----------------------------- = -------------------- = 0.67
Shareholders’ funds 3,00,000

(v) Stock turnover ratio:

Cost of goods sold 5,00,000

(a) As regards average total inventory = ---------------------------- = ----------------- = 2.5
Average inventory* 2,00,000

(*) of raw materials as well as finished goods)

(b) As regards average inventory of finished goods:

Cost of goods sold 5,00,000
-------------------------------------------------- = ---------------- = 5
Average inventory of finished goods 1,00,000

(c) As regard average inventory of raw materials:

Materials consumed 2,00,000
-------------------------------------------------- = ---------------- = 2
Average inventory of materials 1,00,000

Liquid assets 1,50,000

(iv) Liquid Ratio: ------------------------- = ----------------- = 1
Current liabilities 1,50,000

ILLUSTRATION 2 : Following are the ratios to the trading activities of National Traders

Debtor’s Velocity 3 Months

Stock Velocity 8 Months
Creditor’s Velocity 2 Months
Gross Profit Ratio 25 percent

Gross profit for the year ended 31st December, 1988 amount to Rs. 4,00,000/- closing
stock of the year is Rs. 10,000 above the opening stock. Bills receivable amount to Rs.
25,000 and Bills payable to Rs. 10,000.

Find out: (a) Sales, (b) Sundry Debtors; (c) Closing Stock & (d) Sundry Creditors


(a) Sales:

Gross profit
Gross Profit Ratio = ------------------------- x 100

Gross profit = Rs. 4,00,000/-

Sales = ----------------------------- x 100 = Rs. 16,00,000

(b) Sundry Debtors :

Debtor’s Velocity = --------------------- x 12

“Debtor’s Velocity of 3 months” Presumably means that Accounts Receivable equal to 3

months’ Sales or ¼ of the year’s sales.
Account Receivable = --------------------- x 1 4,00,000

Less Bills Receivable 25,000

Sundry Debtors 3,75,000

(c) Closing Stock:

Cost of goods sold
Stock Velocity = ------------------------------------------
Average stock

Cost of goods sold = Sales – Gross profit

= 16,00,000 – 4,00,000 = Rs. 12,00,000

Average Stock = ------------------------- x 8 = Rs. 8,00,000

Total of Opening and Closing stock = 8,00,000 x 2 = 16,00,000

Closing Stock is higher than Opening Stock by Rs. 10,000

16,00,000 - 10,000
Therefore, Opening Stock = ---------------------------------
= 7,95,000

Hence, Closing Stock = 7,95,000 + 10,000 or Rs. 8,05,000

(d) Sundry Creditor’s:

Total Creditor’s
Creditor’s Velocity i.e., = ------------------------------ x 12

Purchases = Cost of goods sold + Closing Stock – opening Stock

= 12,00,000 + 8,05,000 – 7,95,000 = Rs. 12,10,000

Creditor’s Velocity is 2 months, it means that Account Payable are 1/6th of the
Purchases for the year

Hence Account Payable = Rs. 2,01, 667

Less : Bills Payable = 10,000
Sundry Creditor’s Rs. 1,91,667

The technique of Funds Flow Analysis is widely used by the financial analyst, credit
granting institutions and financial managers in performance of their jobs. It has become
a useful tool in their analytical kit. This is because the financial statements, i.e., “Income
Statement” and the “Balance Sheet” have a limited role to perform. Income statement
measures flow restricted to transactions that pertain to rendering of goods or services to
customers. The Balance Sheet is merely a static statement. It is a statement of assets
and liabilities which does not focus major financial transactions which have been behind
the balance sheet changes. One has to draw inferences after comparing the balance
sheets of two periods. For example, if the fixed assets worth Rs. 2,00,000 are
purchased during the current year by raising share capital of Rs. 2,00,000 the balance
sheet will simply show a higher capital figure and higher fixed assets figure. In case,
one compares the current year’s balance sheet with the previous year, then only one
can draw an inference that fixed assets were acquired by raising share capital of Rs.
2,00,000. Similarly, certain important transaction which might occur during the course of
the accounting year might not find any place in the balance sheet. For example, if a loan
of Rs. 2,00,000 was raised and paid in the accounting year the Balance sheet will not
depict this transaction. However, a financial analyst must know the purpose for which
the loan was utilized and the source from which it was raised. This will help him in
making a better estimate about the company’s financial position and policies.

The term “fund” generally refers to cash, to cash and cash equivalents, or to working
capital. Of these the last definition of the term is by far the most common definition of

There are also two concepts of working capital – gross and net concept. Gross working
capital refers to the firm’s investment in current asset while the term net working capital
means excess of current assets over current liabilities. It is in the latter sense in which
the term ‘funds’ is generally used.

Current Assets: The term ‘Current Assets’ includes assets which are acquired with the
intention of converting them into cash during the normal business operations of the

The broad categories of current assets, therefore, are

1. Cash including fixed deposits with banks.
2. Accounts receivable, i.e., trade debtors and bills receivable,
3. Inventory i.e., stocks of raw materials, work-in-progress, finished goods, stores
and spare parts.
4. Advances recoverable, i.e., the advances given to supplier of goods and services
or deposit with government or other public authorities, e.g., customer, port
authorities, advance income tax, etc.
5. Pre-paid expenses, i.e. cost of unexpired services e.g., insurance premium paid
in advance, etc.

Current Liabilities: The term ‘Current Liabilities’ is used principally to designate such
obligations whose liquidation is reasonably expected to require the use of assets
classified as current assets in the same balance sheet or the creation of other current
liabilities or those expected to be satisfied within a relatively short period of time usually
one year. However, this concept of current liabilities has now undergone a change. The
more modern version designates current liabilities as all obligations that will require
within the coming year or the operation cycle, whichever is longer. The use of existing
current assets or the creation of other current liabilities . in other words, the more fact
that an amount is due within a year does not make it current liability unless it is payable
out of existing current assets or by creation of current liabilities. For example
debentures due for redemption within a year of the balance sheet date will not be taken
as a current liability if they are to be paid out of the proceeds of a fresh issue of shares /
debentures or out of the proceeds realized on account of sale of debentures redemption
fund investments.

The term current liabilities also includes amounts set apart or provided for any known
liability of which the amount cannot be determined with substantial accuracy e.g.,
provision for taxation, pension etc., These liabilities are technically called provisions
rather than liabilities.

The broad categories of current liabilities are:

1. Accounts payable e.g., bill payable and trade creditors.

2. Outstanding expenses, i.e., expenses for which services have been received by
the business but for which the payment has not made.
3. Bank-over drafts.
4. Short-term loans, i.e., loans from banks, etc., which are payable within one year
from the date of balance sheet.
5. Advance payments received by the business for the services to be rendered or
goods to be supplied in future.
6. Current maturities of long-term loans, i.e., long-term debts due within a year of
the balance sheet date or installments due within a year in respect of these
loans, provided payable out of existing current assets or by creation of current
liabilities, as discussed earlier. However, installments of long-term loans due
after a year should be taken as non-current liabilities.

Meaning of “Flow of Funds” The term “Flow” means change and therefore, the term
“Flow of Funds” means “Change in Funds” or “Change in working capital”. In other
words, any increase or decrease in working capital means “Flow of Funds”.


Funds flow statement helps the financial analyst in having a more detailed analysis and
understanding of changes in the distribution of resources between two balance sheet
dates. In case such study is required regarding the future working capital position of the
company, a projected funds flow statement can be prepared. The uses of funds flow
statement can be put as follows.

1. It explains the financial consequences of business operations. Funds flow

statement provides a ready answer to so many conflicting situations, such as:

• Why the liquid position of the business is becoming more and more unbalanced
inspite of business making more and more profits.
• How was it possible to distribute dividends in excess of current earnings or in the
presence of a new loss for the period?
• How the business could have good liquid position in spite of business making
losses or acquisition of fixed assets?
• Where have the profits gone?

Definite answers to these questions will help the financial analyst in advising his
employer / client regarding directing of funds to those channels which will be most
profitable for the business.

2. It answers intricate queries. The financial analyst can find out answers to a
number of intricate questions.

• What is the overall credit-worthiness of the enterprise?

• What are the sources of prepayment of the loans taken?
• How much funds are generated through normal business operations?
• It what way the management has utilized the funds in the past and what are
going to be likely use of funds?
• It acts as an instruments for allocation of resources.
• It is a test as to effective or otherwise use of working capital .


In order to prepare a Funds Flow Statement, it is necessary to find out the “sources”
and “applications” of funds.

Sources of funds. The sources of funds can be both internal as well as external.

Internal Sources: Funds from operations is the internal source of funds. However,
following adjustments will be required in the figure of Net Profit for finding out real
funds from operations.
Add the following items as they do not result in outflow of funds:
1. Depreciation on fixed assets
2. Preliminary expenses or goodwill, etc., written off.
3. Contribution of debenture redemption find, transfer to general reserve, etc, if they
have been deducted before arriving at the figure of net profit.
4. Provision for taxation and proposed dividend are usually taken as appropriations
of profits only and not current liabilities for the purposes of Funds Flow
Statement. This is being discussed in detail later. Tax or dividends actually paid
are taken as applications of funds. Similarly, interim dividend paid is shown as an
applications of funds. All these items will be added back to net profit, if already
deducted, to find funds from operations.
5. Loss on sale of fixed assets.

Deduct the following items as they do not increase funds;

1. Profit on sale of fixed assets since the full sale proceeds are taken as a separate
source of funds and inclusion here will result in duplications.
2. Profit on revaluation of fixed assets.
3. Non-operating incomes such as dividend received or accrued dividend, refund of
income tax, rent received or accrued rent. These items increase funds but they
are non-operating incomes. They will be shown under separate heads as
‘source of funds’ in the Funds Flow Statement.
In case the profit and Loss Account shows “Net Loss”, this should be taken as an item
which decreases the funds.

External Sources: These sources includes-

1. Funds from long-term loans

2. Sale of fixed assets
3. Funds from increase in share capital
4. Application of funds
5. Purchase of fixed assets
6. Payment of dividends
7. Payment of fixed liabilities.
8. Payment of tax liability.

Technique for preparing a funds flow statement

A funds flow statement depicts change in working capital. it will, therefore, be better for
the students to prepare first a Schedule of Changes in Working Capital before preparing
a funds flow statement.

Schedule of changes in working capital

The schedule of changes in working capital can be prepared by comparing the current
assets and the current liabilities of two periods. It may be in the following form.
Items As As on Change
--- --- Increase Decrease
(+) (-)
Current Assets
Cash balance
Bank balance
Marketable securities
Accounts receivable
Prepaid expenses
Current Liabilities
Bank overdraft
Outstanding expenses
Accounts payable
Net Increase / Decrease in Working Capital

Rules for preparing the Schedules:

1. Increase in a current asset, result in increase (+) in “working capital”
2. Decrease in current asset, results in decrease (-) in “working capital”
3. Increase in a current liability, results in decrease (-) in “Working capital”
4. Decrease in a current liability, results in increase (+) in “Working capital”

Funds – flow statement

While preparing a funds flow statement, current assets and current liabilities are to
be ignored. Alternation is to be given to changes in Fixed Assets and Fixed
Liabilities. The statement may be prepared in the following form.
Sources of funds: Rs. Application of Funds Rs.
Issue of Shares --- Redemption of Redeemable ---
Issue of Debentures --- Preference Shares ---
Long-term Borrowing --- Redemption of Debentures ---
Sale of Fixed Assets --- Payment of other long-term loans ---
Operating profit* --- Operating Loss* ---
Decrease in working capital --- Payment of dividend, tax, etc. ---
Increase in working capital* ----

* Only one figure will be there.

The change in working capital disclosed by the ‘schedule of changes in working capital
will tally with the change disclosed by the ‘funds flow statement’.

Illustration 1:
From the following balance sheet of X Ltd. On 31st December 1985 and 1986, you are
required to prepare.

1. A schedule of changes in working capital

2. A funds flow statement
Liabilities 1985 1986 Assets 1985 1986
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000
General Reserve 14,000 18,000 Building 40,000 36,000
Profit & Loss A/c 16,000 13,000 Plant 37,000 36,000
Sundry Creditors 8,000 5,400 Investments 10,000 11,000
Bills Payable 1,200 800 Stock 30,000 23,400
Provision for 16,000 18,000 Bill Receivable 2,000 3,200
Provision for 400 600 Debtors 18,000 19,000
doubtful debts
Cash at Bank 6,600 15,200

1,55,600 1,55,800 1,55,600 1,55,800

The following additional information has also been given.

1. Depreciation charged on Plant was Rs. 4,000 and on Building Rs. 4,000
2. Provision for taxation of Rs. 19,000 was made during the year 1986.
3. Interim dividend of Rs. 8,000 was paid during the year 1986.
1985 1986 Increase Decrease
(+) (-)
Current Assets: Rs. Rs. Rs. Rs.
Cash at Bank 6600 15200 8600
Debtors 18000 19000 1000
Bills receivable 2000 3200 1200
Stock 30000 23000
Current Liabilities 6600
Provision for doubtful debts 400 600 200
Bills payable 1200 800 400 ---
Sundry Creditors 8000 5400 2600 ---

Total 13800 6800


Sources Rs.
Funds from operations 36000
Total sources 36000
Applications: Rs.
Purchase of plant 3000
Tax paid 17000
Investments purchased 1000
Interim dividend paid
Total application 29000
Net increase in working capital 7000
Working Notes:
1. Funds from operations: Rs. Rs.
Profit & Loss account balance on 31st Dec., 1986 13000
Add: Items which do not decrease funds from
Transfer to General Reserve 4000
Provision for Tax 19000
Plant 4000
Building 4000
Interim Dividend paid 8000 39000
Less: Profit & Loss balance on 31st Dec., 1988 16000

Funds from operations for the year 36000

2. Purchase of Plant. This has been found out by preparing the Plant Account.

Plant Account
To balance b/d 37000 By Depreciation 4000
To bank 3000 By balance c/d 36000

(Purchase of plant balancing figure) 40000 40000

3. Tax paid during the year has been found out by preparing a Provision for Tax

Provision For Tax Account

To blank By balance b/d 16000
(being tax paid – balancing figure) 17000 By P & L A/c 19000
To balance c/d 18000

35000 35000
4. ‘Investment’ have been taken as a fixed asset presuming that they are long-term


Cash flow analysis is another important technique of financial analysis. It involves

preparation of Cash flow statement for identifying sources and applications of cash. A
cash flow statement is a statement depicting change in cash position from one period to
another. For example, if the cash balance of business is shown by its Balance sheet on
31st December, 1978 at Rs. 20,000 while the cash balance as per its balance sheet on
31st December, 1979 is Rs. 30,000. There has been an inflow of cash of Rs. 10,000 in
the year 1979 as compared to the year 1978. The cash flow statement explains the
reasons for such inflows or outflows of cash, as the case may be. It also helps
management in making plans for the immediate future.

A cash flow statement can be prepared on the same pattern on which a funds flow
statement is prepared. The change in the cash position from one period to another is
computed by taking into account “Sources” and “Application” of cash.

Format of a Cash Flow Statement

A cash flow statement can be prepared in the following form:

Cash Flow Statement
For the year ending on ...
Balance as on 1.1.19...
Cash balance ......
Bank balance ......
Issue of Shares .....
Raising of long-term loans ......
Sale of fixed assets ......
Short-term borrowings ......
Cash from operation ......
Profit as per Profit and Loss Account ......
Add/Less : Adjustment for non-cash items
Add: Increase in current liabilities
Decrease in current assets ......
Less: Increase in current assets .....
Decrease in current liabilities ......
Total cash available (1)
Less: Application of Cash:
Redemption of redeemable preference ......
Redemption of long-term loans ......
Purchase of fixed assets ......
Decrease in deferred payment liabilities ......
Cash outflow on account of operation ......
Tax paid ......
Dividend paid ......
Decrease in unsecured loans, deposits etc., ......
Closing balances*
Cash balance ......
Bank Balance ......
* There total should tally with the balance as shown by (1) – (2)

Following are the points of difference between a Cash Flow Analysis and a Funds

1. A cash flow statement is concerned only with the change in cash position while a
funds flow analysis is concerned with changed in working capital position
between two balance sheet dates. Cash is only one of the constituents of
working capital besides several other constituents such as inventories, accounts
receivable, prepaid expenses.
2. A cash flow statement is merely a record of cash receipts and disbursements. Of
course, it is valuable in its own way but if fails to bring to light many important
changes involving he disposition of resources. While studying the short-term
solvency of a business one is interested not only in cash balance but also in the
assets which are easily convertible into cash.
3. Cash flow analysis is more useful to the management as a tool of financial
analysis in short period as compared to funds flow analysis. It has rightly been
said that shorter the period covered by the analysis, greater is the importance of
cash flow analysis. For example, if it is to be found out whether the business can
meet it obligations maturing after 10 years from now, a good estimate can be
made about firm’s capacity to meet its long-term obligations if changes in working
capital position on account of operations are observed. However, if the firm’s
capacity to meet a liability maturing after one months is to be seen, the realistic
approach would be to consider the projected change in the cash position rather
than an expected change in the working capital position.
4. Cash is part of working capital and, therefore, an improvement in cash position
results in improvement in the funds position but the reverse is not true. In other
words, “inflow of cash” results in ‘inflow of funds’ but inflow of funds may not
necessarily result in “inflow of cash”. Thus, a sound funds position does not
necessarily mean a sound position but a sound cash position generally means a
sound funds position.
5. Another distinction between a cash flow analysis and a funds flow analysis can
be made on the basis of the techniques of their preparation. An increase in a
current liability or decrease in a current asset results in decrease in working
capital and vice verse. While an increase in a current liability or decrease in a
current asset (other than cash) will result in increase in cash and vice versa.

Some people, as stated before, use of term “funds” in a very narrow sense of ‘cash’
only. In such an event the two terms ‘Funds’ and ‘Cash’ will have synonymous meaning.
1. Helps in efficient cash management
2. Helps in internal financial management
3. Discloses the movement of cash
4. Discloses success or failure of cash planning


1. Cash flow statement cannot be equated with the Income Statement. An income
statement takes into account both cash as well as non-cash items and, therefore,
net cash flow does not necessarily mean net income of the business.
2. The cash balance as disclosed by the cash flow statement may not represent the
real liquid position of the business since it can be easily influenced by postponing
purchases and other payments.
3. Cash flow statement cannot replace the Income Statement or the Funds flow
statement. Each of them has a separate function to perform.

Illustration 1

From the following balances you are required to calculate cash from operations:

Debtors 1987 1988

Rs. Rs.
Bills receivable 50,000 47,000
Creditors 10,000 12,000
Bills payable 20,000 25,000
Outstanding expenses 8,000 6,000
Prepaid expenses 1,000 1,200
Prepared expenses 800 700
Accrued Income 600 750
Income received in advance 300 250
Profit made during the year .... 1,30,000
Profit made during the year .... 1,30,000
Decrease in Debtors 3000
Increase in Creditors 5000
Increase in outstanding expenses 100 8300
Increase in Bills Receivable 2500
Decrease in Bills payable 2000
Increase in Accrued Income 150
Decrease in Income received in advance 50 4700
Cash from operation 133600

Illustration 2:
Balance Sheets of A and B on 1.1.1988 and 31.12.1988 were as follows:

1.1.88 31.12.88 1.1.88 31.12.88
Liabilities Rs. Rs. Assets Rs. Rs.
Creditors 40,000 44,000 Cash 10,000 50,000
Mrs. A’s 25,000 .... Debtors 30,000 50,000
Loan from 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Building 35,000 60,000

2,30,000 2,47,000 2,30,000 2,47,000

During the year of a machine costing Rs. 10,000 (accumulated depreciation Rs. 3,000)
was sold for Rs. 5,000. The provision for depreciation against Machinery as on 1.1.1988
was Rs. 25,000 and on 31.12.1988 Rs. 40,000. Net profit for the year 1988 amounted to
Rs. 45,000. You are required to prepare Cash Flow Statement.
Cash Flow Statement
Cash balance as on 1.1.1988 Rs. 10,000
Add: Sources
Cash from Operations Rs. 59,000
Loan from Bank 10,000
Sale of Machines 5,000 74,000
Less: Applications:
Purchase of Land 10,000
Purchase of Building 25,000
Mrs. A’s Loan repaid 25,000
Drawings 17,000 77,000
Cash Balance as on December 31, 1988 7,000

Working Notes


Profit made during the year Rs. 45,000
Add: Depreciation on Machinery 18,000
Loss on Sale of Machinery 2,000
Decrease in Stock 10,000
Increase in Creditors 4,000 34,000
Less: Increase in Debtors 20,000
Cash from Operation 59,000
Machinery Account (At Cost)
To Balance b/d 1,05,000 By Bank 5,000
By Loss on Sale of machinery 2,000
By provision for Depreciation 3,000
By balance c/d 95,000

1,05,000 1,05,000


To machinery A/c 3,000 By balance b/d 25,000

To balance c/d 40,000 By P & L A/c 18,000
(depreciation charged –
balancing figure)

43,000 43,000

The management is efficient if it is able to accomplish the objective of the enterprise. It

is efficient when it accomplishes the objectives with minimum effort and cost. In order to
attain long-range efficiency and effectiveness, management must chart out its course in
advance. A systematic approach to facilitate effective management performances profit-
planning and control, or budgeting. Budgeting is therefore an integral part of
management. In a way, a budgetary control system has been described as a historical
combination of a “goal – setting machine for increasing an enterprise’s profits, and a
goal-achieving machine for facilitating organizational coordination and planning while
achieving the budgeted targets.”

The Institute of Cost and Management Accountants, London, gives the following

A budget is “a financial and / or quantitative statement, prepared and approved prior to

a defined period of time, of the policy to be pursued during that period for the purpose of
attaining a given objective. It may include income, expenditure and the employment of

Budgetary control. “The establishment of departmental budgets relating the

responsibilities of executive to the requirements of a policy, and the continuous
comparison of actual with budgeted results, either to secure by individual action the
objectives of the policy, or to provide a firm basis for its revision.”

Thus, a budget is a predetermined statement of management policy during a given

period which provides a standard for comparison with the results actually achieved.
Budgetary control is a system of controlling costs which includes the preparation of
budgets, coordinating the departments and establishing responsibilities, comparing
actual performance with that of budgeted and acting upon results to achieve maximum
profitability. Budgeting is essentially concerned with planning, and can be broadly
illustrated by comparison with the routine a ship’s captain follows on each voyage.

Operation of Budgetary Control

The steps involved in a Budgetary Control system can be outlined as follows:

1. Establish a plan or target of performance which coordinates all the activities of
the business.
2. Record the actual performance
3. Compare the actual performance with that planned.
4. Calculate the differences, or variances, and analyze use reasons for them.
5. Act immediately, if necessary, to remedy the situation.

Objectives of Budgetary Control

Briefly, the main objectives of budgetary control are:

1. To combine the ideas of all levels of management in the preparation of the

2. To coordinate all the activities of the business.
3. To centralize control.
4. To decentralize responsibility to each manager involved.
5. To act as a guide for management decision-making when unforeseeable
conditions affect the business.
6. To plan and control income and expenditure so that maximum profitability is
7. To direct capital expenditure in the most profitable direction.
8. To ensure that sufficient working capital is available for the efficient operation of
the business.
9. To provide a yardstick against which results can be compared.
10. To show management where action is needed to remedy a situation.

Basic Conditions for the Successful Operation of Budgetary Control

Realistic Budget: The quality of the budget is very important for the successful operation
of budgetary control. If should be realistic and operationally feasible. Flexible budget is
normally a good budget as it take into consideration the dynamics of the business. It
must be based on what is attainable, must suit the organizational facilities and
complexities and must be flexible to accommodate the changing environment of the

Qualitative and Timely Reporting : Variances must be analyzed, interpreted and

reported in a manner which is easily understandable. Reporting must be on time and
bring out significant areas/points and be precise, simple and meaningful. Time is the
essence of reporting and maintenance of time schedule enhances the value of reporting
and leads to correction of many adverse events/trends which otherwise would have
taken a heavy toll.

Management’s Attitude: The management must have a positive attitude towards

budgetary control. Any scheme of control is a discipline and regulation. Management
must have faith and confidence in the scheme. Management must take keen interest in
the scheme of budgetary control and render whole-hearted support and cooperation in
making this a success.

Advantages of Budgetary Control

The following are some of the most significant advantages of budgeting :

1. Budgeting compels management to plan for the future. The budgeting process
forces management to look ahead and become more effective and efficient in
administering business operations. It instills into managers the habit of evaluating
carefully their problems and related variables before making any decisions.
2. Budgeting helps to coordinate, integrate, and balance the efforts of various
departments in the light of the overall objectives of the enterprise. This results in
goal congruency and harmony among the departments.
3. Budgeting facilitates control by providing definite expectations in the planning
phase that can be used as a frame of reference for judging the subsequent
performance. Undoubtedly, budgeted performance is a more relevant standard
for comparison than past performance is based on historical factors which are
constantly changing.
4. Budgeting improves the quality of communication. The enterprise’s objectives,
budgets goals, plans, authority and responsibility and procedures to implement
plans are clearly written and communicated through budgets to all individuals in
the enterprise. This results in better understanding and harmonious relating
among mangers and subordinates.
5. Budgeting helps to optimize the use of the firm’s resources, both capital and
human. It aids in directing the total efforts of the firm into the most profitable
6. Budgeting increase the morale and thereby the productivity of the employees by
seeking their meaningful participation in the formulation of plans and policies,
bringing about a harmony between individual goals and the enterprise’s
objectives, and by providing incentives for better performance.
7. Budgeting develops profit-mindedness and cost consciousness.
8. Budgeting permits the management to focus attention on significant matters
through budgetary reports. Thus, it facilitates management by exception and
thereby saves the management’s time and energy.
9. Budgeting measure efficiency and thereby enables self-evaluation by the
management, it also indicates the progress made in attaining the enterprise’s

Problems of the Budgeting System

The major problems in developing a budgeting system are:

1. Getting the support and involvement of all levels of management.

2. Developing meaningful forecasts and plans, especially the sales plan.
3. Inducing all individuals to get involved in the budgeting process, and gaining their
full participation.
4. Establishing realistic objectives, procedures and standards of desired
5. Applying the budgeting systems in a flexible manner.
6. Maintaining effective follow-up procedures, and adapting the budgeting system to
changing circumstances.

Limitations of Budgetary Control

Management must consider the following limitations in using the budgeting system as a
device to solve managerial problems:

1. Budgeting is not an exact science, its success depends upon the precision of
estimates. Estimates are based on facts and managerial judgement. Managerial
judgement can suffer from subjectivity and personal biases. The efficacy of
budgeting thus depends upon the quality of managerial judgement.
2. A perfect system of budging cannot be organized in a short period. Business
conditions change rapidly. Therefore, the budging system should be continuously
adapted to changing circumstance. Budgeting has to be a continuous exercise, it
is a dynamic process. Management should not lose patience, it should go on
trying various techniques and procedures in developing and using the budgeting
3. A skillfully prepared budget system will not by itself improve the management of
an enterprise unless it is properly implemented. For the success of the budgetary
system, it is essential that it is understood by all, and that the managers and
subordinates put in concerted effort for accomplishing the budget goals. All
persons in the enterprise must be fully involved in the preparation and execution
of budgets, otherwise budgeting will not be effective.
4. Budgeting is a management tool, a way of managing, not the management itself.
The presence of a budgetary system should not make management complacent.
To get the best results, management should use budgeting with intelligence and
foresight, along with other managerial techniques. Budgeting assets
management, it cannot replace management.
5. Budgeting will be ineffective and expensive if it is unnecessarily detailed and
complicated. A budget should be precise in format and simple to understand, it
should be flexible in application.
6. Budgeting will hide inefficiencies instead of revealing them if there is not
evaluation system. There should be continuous evaluation of the actual
performance. The standards should also be re-examined regularly.

Organisation for Budgetary Control

1. Creation of budget centres. Centres of departments should be established for

each of which budgets can be set with the help of the head of department
concerned. A budget centre is a centre or department or a segment of a an
organisation for which budgets are prepared. Budgets should be set with the help
of the heads of these centres so that these may be implemented more
2. Preparation of an organisatoin chart. This defines the functional responsibilities
of each member of the management, and ensures that he knows his position in
the company and his relationship with other members.
3. Establishment of a budgeted committee. In small companies budget officer or
the accountant may coordinate all the work connected with budgets, but in large
companies a budget committee is often established to formulate a general
programme for preparing budgets and exercising overall control. The Chief
Executive of the company may establish guiding principles but usually he
delegates the responsibility for operating the system to the budget officer as
secretary of the committee. This committee is composed of the chief executive,
budget officer and heads of the main department such as those shown in Fig. 1.
Each member will prepare his own initial budget or budgets, which will then be
considered by the committee, and all budgets will be coordinated. Usually many
changes are necessary before the budgets can be finally integrated and
4. Preparation of budget manual. This ia defined (by the I.C.M.A.) as a document
which sets out the responsibilities of the persons engaged in the routine of, and
the forms and records required for budgetary control. It is usually in loose-leaf
form so that alternations can easily be made as and when required, appropriate
sections can be issued to executives requiring them. An index will be provided so
that information can be located quickly. Such a manual will usually prove
invaluable, as it will include information such as:

(a) Description of the system and its objectives,

(b) Procedure to be adopted in operating system
(c) Definitions of responsibilities and duties
(d) Reports and statements required for each budget period
(e) The accounts code in use.
(f) Deadline by which data are to be submitted.

5. Budget Period: There is no “right” period for any budget. Budget periods may be
short term and long term. If a business experiences seasonal fluctuations, the
budget period will probably extend over one seasonal cycle. If this cycle covers,
say two or three years, the long-term budget would cover the period, while the
short-term budgets would perhaps be preparation on a monthly basis for control
purpose. Short-term budgeting is usually costly to prepare and operate, while
long-term budgeting may be considerably affected by unforeseen conditions.
Budget periods frequently used in industry vary between one month and one
year, the latter probably being the most commonly used as it fits in with the
normally accepted accounting period. However, forecasts of much longer
periods than a year may be used in the case of capital expenditure budgets, for
example, which must be planned well in advance. A common practice in industry
is to have a series of budget periods. Thus, the sales budget may cover the next
five years, while production and cost budgets may cover only one year. These
yearly budgets will be broken down into quarterly or even monthly periods.
Where long-term budgets are operated it is usual to supplement them with short-
term ones.
6. The key factor. This is the factor whose influence must first be assessed in order
to ensure that functional budgets are reasonably capable of fulfillment. The key
factor-known variously as the “limiting” or “governing” or “principle budget” factor
is of vital importance. It may not be the same for each budget period, as the
circumstances may change. It determines priorities in functional budget. Among
the many key factors which may affect budgeting are the following:
a. Management
i. Lack of capital, restricting policy
ii. Lack of knowhow
iii. Inefficient executives
iv. Insufficient research into product design and methods.

Classification of Budgets
Though budgets can be classified according to various points of view the following
bases of classification are generally in vogue:

(a) Classification according to time factor

(b) Functional classification
(c) Classification according to flexibility factor.

(A) Classification according to time factor.

(1) Long-term Budgets (2) Short-term Budgets (3) Current Budgets: They cover a
period of a month or so and as shot-term budgets, they get adjusted to prevailing
circumstances. Sometimes, within the framework of a short-term budget, there
are quarterly plans which are prepared by recasting the budget for a still shorter
period on the basis of the performance of the immediate past. In a way, these
quarterly budgets are meant to be an elaboration of the annual budget.

(B) Functional Classification

(1) Sales Budget, (2) Production Budget, (3) Personnel Budget (4) Purchase
Budget : Correlated with sales forecast and production planning, it deals with
purchases that are required for planned production. purchase would include
both direct and indirect materials and goods. (5) Research Budget (6) Cash
Budget (7) Capital Budget (8) Master Budget (9) Plant utilization Budget (10)
Office and Administration Budget. This budget represents cost of all
administrative expenses, such as managing director’s salary, staff salaries
and expenses of office management like lighting and cleaning.

(C) Classification According to Flexibility

(1) Fixed Budget: This is budget in which targets are rigidly fixed. Such budgets
are usually prepared from one to three months in advance of the fiscal year to
which they are applicable. Thus, twelve months or more may elapse before
figures forecast for the December budget Are used to measure actual
performance. Many things may happen during this intervening period and
they mayh make the figures go widely out of the line with the actual figures.
Thought it is true that a fixed, or static budget as it is sometimes called, can
be revised whenever the necessity arises, it smacks of rigidity and artificially
so far as control over costs and expenses are concerned. Such budgets are
preferred only where sales can be forecast with the greatest of accuracy
which means, in turn, that the cost and expenses in relation to sales can be
quite accurately ascertained.
(2) Flexible Budget


This is a forecast of total sales expressed and incorporated in quantities and / or money.
A sales budget may be prepared by expressing turnover under any one or combination
of the following:

1. Product or product group;

2. Territories, areas and countries;
3. Types of customers, e.g., National, Government, export, home, wholesales, or
4. Salesman, agents or representatives, and
5. Period; such as quarters, months, weeks, etc.

A sales budget may be prepared with the help of any one or more of the following

(1) Analysis of past sales: Analysis of past sales for a number of years, say 5 to 10
years, viz. long-term trend, seasonal trend, cyclical trend, sundry other factors.
The long-term trend represents the movement of the fortunes of a business over
many years. The seasonal trend may affect many types of business and hence
this factor must be taken into account when studying figures for consecutive
months over a number of years. The cyclical trend represents the fluctuations in
the business activity due to the effect of the trade cycle. In order to study the
cyclical trend it is desirable to disregard the effects to the long-term and seasonal
trends. Sundry factors include, such as a strike in the industry or a serious fire or
flood. From such analysis it will be possible to suggest future trends. In analyzing
such sales, considerable help can be obtained from statistical reports produced
by the trade units and commercial intelligence units, government publications,
(2) Studying the impact of factors affecting sale: Any change in the company policy
or method should always be considered. For example, introduction of special
discounts special salesmen, a new design of the product, new or additional
advertising campaigns, improved deliveries, after-sales service should have
some market effect on a sales budget. While preparing such forecasts, the sales
manager must consider the opinion of divisional managers and other sales staff,
the budget officer and the accountant. It will be observed that the preparation of a
sales budget involves many factors and calls for a high degree of knowledge of
conditions, and if ability to deduce fro the known facts and various estimates the
probable course of sales budget is prepared first. If production is the key factor,
the production budget should be built up first and the sales budget must be
drawn up within up within the limits imposed by the production budget.

Illustration 1
AB Co. Ltd. manufactures two products, A and B, and sells them through two divisions –
North and South. For the purpose of submission of sales budget to the budget
committee, the following information has been made available.

Product North South

A 4,000 at Rs. 9 6,000 at Rs. 9
B 3,000 at Rs. 21 45,000 at Rs. 21

Actual sales of the current year were:

Product North South
A 5,000 at Rs. 9 6,000 at Rs. 9
B 2,000 at Rs. 21 4,000 at Rs. 21

Market studies reveal that the product A, is popular but under-period. It is observed that
if the price of A is increased by Re. 1 it will still find a ready market. On the other hand,
B is over-period to customers and the market could absorb more if the sales price of B
is reduce by Re. 1. The management has agreed to give effect to the above price

From the information relating to these price changes and reports from salesman, the
following estimates have been prepared by divisional managers. Percentage increase in
sales over current budget is:
Product North South
A +10% +5%
B +20% +10%
Additional sales above the estimated sales of divisional managers are:
Product North South
A 600 units 700 units’
B 400 units 500 units
Prepare a Sales Budget

Sales Budget
A B Co. Ltd.
For the Year : 19 x 7

Prepared by ......................
Checked by ......................
Submitted on ....................

Division Product Budget for Budget for Current Actual sales for
Future Period Period Unit Price Current Period
Unit Price Value Unit Price
Value Value
Qty Rs Rs. Qty Rs Rs. Qty Rs Rs.
. . .

North A 5,000 10 50,000 4,000 9 36,000 5,000 9 45,000

B 4,000 20 80,000 3,000 21 63,000 2,000 21 42,000
Total 9,000 1,30,000 7,000 99,000 7,000 87,000
South A 7,000 10 70,000 6,000 9 54,000 7,000 9 63,000
B 6,000 20 1,20,000 5,000 21 1,05,000 4,000 21 84,000
Total 13,000 1,90,000 11,000 1,59,000 11,000 1,47,000
Total A 12,000 10 1,20,000 10,000 9 90,000 12,000 9 1,08,000
(Summary) B 10,000 20 2,00,000 8,000 21 1,68,000 6,000 21 1,26,000
Total 22,000 3,20,000 18,000 2,58,000 18,000 2,34,000

Production Budget

Like the sales budget, the production budget is built up in terms of quantities and
money. The quantities are entered at the beginning and, when the remainder of the
budget have been built up and the cost of production calculated, the costs are entered
to compile a production cost budget. In preparing the production budget, consideration
should be given to the following:

(1) Principal budget factor, e.g., if sales be the budget factor then it should be the
sales budget; otherwise other budgets.
(2) Production planning and determination of optimum factory capacity.
(3) The opening stocks, and stocks required to be carried at the end of the period.
(4) The policy of the management regarding manufacture or purchase of

The production budget may be classified under the following heads:

(a) Products
(b) Manufacturing department
(c) Months, quarters, etc.

ABC Col. Ltd.

(Production Budget (in units)
Items A B For the year.....
Sales during the period 12,000 10,000
Required stock on 31st Dec. 1,000 2,000
Total 13,000 12,000
Less Estimated Opening stock 1,000 1,000
Estimated production 12,000 11,000

Purchase Budget
A purchase Budget gives the details of the purchase which must be made to meet the
needs of the business. It includes all items of purchase. Such as raw materials, indirect
materials and other equipments. The purchase budget for raw materials is the most
important and the following factors are required to be considered in preparing this

(1) Opening and closing stocks.

(2) Unfulfilled orders at the beginning of the budget period.
(3) Storage space, economic buying quantity, and financial resources.
(4) The prices to be paid.
Illustration 5
The following information regarding the stocks of materials required for the production
programme of Ramesh Limited is available.

Materials Estimated Estimated Stocks

Consumption (in kg)
during 1983-84 (in
In 1st July 1983 On 30th June 1984
AB 9,03,000 20,000 17,000
GH 6,90,000 10,000 20,000
XY 5,47,000 30,000 33,000

Collating the details given above with the information contained in the Materials Budget,
prepare the Purchase Budget of Ramesh Limited.


Ramesh Limited
Purchase Budget
Particulars AB GH XY
kg. kg kg
Estimate Consumption 9,03,000 6,90,000 5,47,000
Add: Stock required on 30-06-84 17,000 20,000 33,000
Total requirements 9,20,000 7,10,000 5,80,000
Less: Estimated stock on
1st July 1983 20,000 10,000 30,000
Quantity to be purchased 9,00,000 7,00,000 5,50,000
Price per kg (Estimate Re. 1 50 p 40 p
Estimated cost of purchase
of materials (Rs) 9,00,000 3,50,000 2,20,000
Preparation of Cash Budget

A complete system of budgetary control makes the construction of cash budget easy. It
is one of the functional budgets which is prepared along with other budgets. There are
three recognized methods of preparing a cash budget.

(a) The Receipts and Payment Method;

(b) The Adjusted Profit and Loss Method; and
(c) The Balance Sheet Method.

Steps to be Adopted

Cash Receipts Forecast; Cash receipts from sales, debtors, income from sales of
assets and investments and probable borrowings should be forecast and brought into
cash budget. Any lag in payment by debtors or by others shall be considered for
ascertaining further cash inflows.

Cash requirements forecast: Total cash outflows are taken out from operating budgets
for the elements of cost, and from capital expenditure budget for the purchase of fixed
assets. Adjustments are to be made for any lag in payments.

Care must be taken to ensure that outstanding or accruals are excluded from the cash
budget since this method is based on the concept of actual cash flows.

Illustration 6

A newly started company Quick Co. Ltd., wishes to prepare cash budget from January.
Prepare a cash budget for the first six months from the following estimated revenue and
Month Total Sales Material Wages Production Selling and
Overheads distribution
Rs. Rs. Rs. Rs. Rs.,
Jan. 20,000 20,000 4,000 3,200 800
Feb. 22,000 14,000 4,400 3,300 900
Mar. 24,000 14,000 4,600 3,300 800
Apr. 26,000 12,000 4,600 3,400 900
May. 28,000 12,000 4,800 3,500 900
June 30,000 16,000 4,800 3,600 1,000

Cash balance on 1st January was Rs. 10,000. A new machine is to be installed at Rs.
30,000 on credit, to be repaid by two equal installments in March and April.

Sales commission @ 5% on total sales is to be paid within the month following actual
sales. Rs. 10,000 being the amount of 2nd call may be received in March. Share
premium amounting to Rs. 2,000 is also obtainable with 2nd call.

Period of credit allowed to suppliers 2 months

Period of credit allowed to customers 1 month
Delay in payment of overheads 1 month
Delay in payment of wages ½ month

Assume cash sales to be 50% of total sales.

Quick Co. Limited

Cash Budget
For the period January to June 1984
Details Jan. Feb. Mar. Apr. May. June
Rs. Rs. Rs, Rs, Rs, Rs.
A Balance b/d 10,000 18,000 29,000 20,000 6,100 8,800
B Receipts: 10,000 11,000 12,000 13,000 14,000 15,000
Cash Sales (50%)
Debtors - 10,000 11,000 12,000 13,000 14,000
Capital - - 10,000 - - -
Share premium - - 2,000 - - -
(A + B) Total 20,000 39,000 64,800 45,000 33,100 37,800
C Payments Material - - 20,000 14,000 14,000 12,000
Wages 2,000 4,200 4,500 4,600 4,700 4,800
Production Overheads - 800 900 800 900 900
Commission - 1,000 1,100 1,200 1,300 1,400
Machinery - - 15,000 15,000 - -
(C) Total 2,000 9,200 44,800 38,900 24,300 22,600
(A+B+C) 18,000 29,800 20,000 6,100 8,800 15,200

Flexible Budgets

In those industries where the pattern of demand is stable, a fixed budget may be
adequate, especially where the budget period is comparatively short. In such
businesses it is possible to forecast sales with a considerable degree of accuracy.
There are many undertakings where stable conditions are absent. In such concerns
fluctuations in output might lead to violent deviations fromd the budget. In such
concerns it is usual to adopt the flexible budgetary technique. A flexible budget is a
budget which is designed to change in accordance with the level of activity actually
attained. If flexible.

The owner of a car knows that the more he uses it per year the more it costs him to
operate it. He also knows that the more he uses his car the less its costs per running
metres. The reason for this lies in the nature of the expenses, some of which are fixed
while others are variable or semivariable. Insurance, taxes, registration, and garaging
are fixed costs; they remain the same whether the car is operated 1,000 or 2,000
kilometers. The costs of tyres, petrol oil, and repair are variable costs and depend
largely upon the kilometers driven. Obsolescence and depreciation result in a combined
type of cost that, although fluctuating to some degree upon the usage of the car, is
semi-variable for it does not vary directly with the usage. The cost of operating the car
per kilometer depends on the number of kilometers the car is used. The mileage
constitutes the basis for judging the activity of the automobile. If the owners prepares an
estimate of total cross and compares his actual expanses with the budget in keeping his
expenses within the allowed limits, unless he takes the mileage factor into account.

Originally, the flexible budget idea was applied principally to the control of departmental
factory overhead. In recent years, however, the idea has been applied to the entire
budget so that production budgets as well as selling and administrative budgets are
prepared on a flexible basis. The construction of a flexible budget is identical with that of
a fixed budget, except that a budget is calculated for each volume ranging from a
possible 60 per cent to 100 per cent of capacity. When actual figures are available
estimate previously determined for the level attained are compared with actual results,
and the differences are noted. This end-of period comparison is used to measure the
performance of each department head. It is this readymade method of comparison that
makes the flexible budget a valuable instrument for cost control. The flexible budget
assists in evaluating the effects of varying volumes of activity on profits and on cash

Illustration 9

The following data are available in a manufacturing company for the half-year period
ending 30th June, 1984.

Fixed expenses: Rs. (Lakhs)

Wages and salaries 8.4
Rent, rates, and taxes 5.6
Depreciation 7.0
Sundry administrative expenses 8.9
Semi-variable expenses @ 50% of
capacity -
Maintenance and repairs 2.5
Indirect labour 9.9
Sales department salaries etc., 2.9
Sundry administrative expenses 2.6

Variable expenses: @ 50% of capacity -

Material 24.0
Labour 25.6
Other expenses 3.8

It is assumed that fixed expenses remain constant for all levels of production’ semi-
variable expenses remain constant between 45% and 65% of capacity, increasing by
10% between 65% and 80% of capacity and 20% between 89% and 100% of capacity.

Sales at the various levels are:

60% capacity Rs. 100.00 lakhs
75% Capacity 120.00 Lakhs
90% Capacity 150.00 Lakhs
100% Capacity 170.00 Lakhs

Prepare a flexible budget for the half-year and forecast the profits at 60%, 75%, 90% of

Flexible Budget for the Half-Year Ending 30th June 1984

(showing the forecast of profit of different levels)

Operating capacity

Elements of cost 50% 60% 75% 90% 100%

A Fixed expenses:
Wages and salaries 8.4 8.4 8.4 8.4 8.4
Rent, rates and taxes 5.6 5.6 5.6 5.6 5.6
Depreciation 7.0 7.0 7.0 7.0 7.0
Sundry expenses 8.9 8.9 8.9 8.9 8.9

29.9 29.9 29.9 29.9 29.9

B. Semi-variable exp:
Maintenance and repairs 2.5 2.5 2.75 3.00 3.00
Indirect labour 9.9 9.9 10.89 11.88 11.88
Sales Dept. salaries 2.9 2.9 3.19 3.48 3.48
Sundry Adm. expenses 2.6 2.6 2.86 3.12 3.12

17.9 17.9 19.69 21.48 21.48

C. Variable expenses:
Material 24.0 28.80 36.00 43.20 48.0
Labour 25.6 30.72 30.47 46.08 51.2
Other expenses 3.8 4.56 5.70 6.84 7.6

53.4 64.08 80.17 96.12 106.8

Total cost of Production 101.2 111.88 129.76 147.50 158.18

(i.e. Total of A, B and C) Profit -11.88 -9.76 +2.50 +11.82
(+) of Loss (-)

Sales 100.00 120.00 150.00 170.00

Less: Bills Payable = 10,000

Sundry Creditors = Rs. 1,91,667



Concept of Capital Expenditure

Every business concern has to face the problem on capital expenditure decisions some
time or the other. Hence, planning for capital expenditure has become an integral part of
policy making, management and budgetary control. Capital expenditure is one which is
intended to benefit future periods and normally includes investment in fixed assets and
other development projects. It is essentially a long-term function, and such for a
decision to buy land, buildings or plant and machinery etc., would influence the activity
of the business for a considerable period of time. Hence, it is essential to keep a close
watch on capital expenditure at all times. Further, the advent of mechanization and
automation has resulted in management being confronted with ever more frequent and
difficult problems. Despite the fact that various techniques have been developed to
assist management in its task of decision-making more effectively, the ultimate decision
depends on the availability of relevant information which can be generated only by well-
established capital expenditure budgeting system. The other commonly used
nomenclatures for capital expenditure decision are “Capital Budgeting”, or “Capital
investment Decision”, or simply “Investment Decisions”.

Concept of capital Budgeting

Capital budgeting normally refers to long-term planning for proposed capital outlays and
their financing. It is the decision-making process by which firms evaluate the acquisition
of major fixed assets whose benefits would be spread over several time periods.
Succinctly, it involves current investment in which the benefits are expected to be
received beyond one year in the future. The use of one year as a line of demarcation is,
however, somewhat arbitrary. The main exercise in capital budgeting is to judge
whether or not an investment proposals provides a reasonable return to investors which
would be consistent with the investment objective of the business. Hence, capital
budgeting involves generation of investment proposals, estimating costs and benefits
(cash flows) for the investment proposals and evaluation of net benefits and selection
of projects based upon an acceptance criterion.

Importance of Capital Budgeting

1. Involves commitment of huge financial resources
The capital investment involved is usually very large. It will have several far-reaching
implications on the activities of business and may even seriously affect the very
financial or flexibility of the business. It is these implications which make capital
budgeting so important.

2. Wrong sale forecast may lead to over-or under-investment of

It shows the possibility of expanding the production facilities to cover additional sales
shown in the sales forecast. In fact the economic life of the asset acquired represents
an indirect sales forecast for the duration of its economic life. Any error in this regord
may result in over-or under-investment in fixed assets, i.e., excess production capacity
or inadequate capacity. It also enables the cash forecast to be completed.

3. Leads to better timing of assets

Capital budgeting may allow altimative forms of assets to be considered as replacement
for assets which are wearing out or are in danger of becoming obsolete in other words,
it would lead to better timing of asset purchases and improvement in quality of assets
purchased. It helps to match efficiently the need for capital goods with their availability.
It also assists in formulating a sound depreciation and asset replacement policy.

4. It ensures the selection of the right source of finance at the

right time.
Capital expenditure decisions involve substantial funds which may not be immediately,
and automatically available. A well – established capital budget would enable the
management to decide in advance the source of finance and ensure their availability at
the right time.

Objective of capital Budgeting

1. Selection of the right mix of profitable projects.

It may be said that the overall objectives of capital budgeting is to allocate the available
investible funds among the competing capital projects in order to maximize the total
profitability. This is made possible by employing the various evaluation techniques for
the selection of investment projects which contribute the maximum towards the overall
investment objective. In the case of public enterprises, capital budgeting may also
assure fulfillment of other objective such as promotion of employment, development of
backward regions, etc.
2. Capital Expenditure control.

Control of capital expenditure is the next important objective of capital budgeting. This is
achieved by forecasting the long-term financial requirements and thereby enabling the
management to plan in advance to raise funds at the right time. The objective of
preparing capital budget is to plan and then compare the actual capital expenditure with
the budgeted figure for controlling costs.

3. Determining the required quantum and the right source of funds for investment.
The next important objective of capital budgeting is to determine the funds required for
long-term project and to see that such estimates fall in line with the company’s financial
policies. It also aims to compromise between the availability of funds and needs of the
capital projects.

Types of capital investment projects

Investment projects may be classified in a number of ways. The following kinds of
investment projects are commonly used by both private and public sector business units
in their capital expenditure forecasts:

(a) Expansion of existing product lines.

(b) Expansion into new product lines.
(c) Replacement and modernization schemes
(d) Projects for the utilization of scraps, and also of surplus installed capacity
(e) Cost reduction projects.

The projects listed above are generally profit-oriented and therefore they may be
evaluated on the basis of their costs and benefits. But there are investments which are
undertaken by all business units and on which it would be difficult to measure returns,
such as the following:

(1) Safty precautions provision of safety devices and equipment may be demanded
by various legal requirements.
(2) Welfare projects: provision of sports facilities for employees may boost
employees morale. This cannot be evaluated financially.
(3) Service projects: provision of buildings and equipment for non manufacturing
departments may be essential, but the return from investment on them cannot be
(4) Research and development: This may be initiated to improve the company
methods or products. It would be very difficult to measure the return on R&D for a
considerable period of time.
(5) Educational projects: Provision of company training course may be instrumental
in improving the efficiency of employment but the returns from investment on
such programmes may be difficult to evaluate.

Relevant cost for capital expenditure decision

Generally, costs and benefits in the form of cash flows are more relevant for capital
budgeting then the conventional accounting cost and benefits because such costs and
benefits normally encounter a number of measurement problems owing the factors such
as method of depreciation, valuation of inventories, write-off etc., Different types of
investment decisions call for different kinds of costs. not all costs which are used in
conventional accounting system are relevant for investment decision making. A few
items of relevant costs are:

Future costs: Future costs are the projected or estimated costs. they are relevant for all
types of investment decision past cost, though not relevant for decision-making, are
useful to the extent that they furnish a starting point for future cost projections. While
calculating these costs, factors such as market conditions, economic conditions, political
situation, general trend in the price levels, probabilities relating to future production and
sales, economic life of the project, etc. are to be taken into account.

Opportunity costs: In simple terms, opportunity cost refers to the benefits of the best
alternative foregone. As the investment in a project involves commitment of the firm’s
investible funds it becomes relevant to consider the opportunity of getting some benefits
by employing the resources on some other alternative. For example, in an expansion
scheme the economic value of the space required rather than its book value is relevant.
In a replacement decision, the realizable value rather then the book value of the old
may be relevant as a reduction of the cost of replacement. This type of cost is relevant
for all types of investment decision. Imputed cost is a kind of opportunity cost. It is the
cost which is not actually incurred, but would be incurred in the absence of self-owned
factors, e.g. cost of retained earnings, rent on company owned facilities, etc.

Incremental or differential cost: It is the additional cost due to a change in the volume of
business or nature of business activity. Hence it is useful for decisions such as adding
new machinery, new – product, changing a distribution channel etc. sometimes this cost
is considered synonymous with marginal cost. But marginal cost has much limited
meaning as it refers to the cost of an added unit of output.

Interest cost : Accounting reports normally ignore the imputed interest on capital which
is relevant for decision-making purposes. Interest cost constitutes the minimum
acceptance criterion for capital investment projects undertaken for profit. A firm must at
least recover its money before it can realize a profit on its own investment.

Depreciation and Income-tax: Depreciation is normally excluded while calculating cash

flows for investment, appraisal and evaluation. But it is included for calculating the
accounting rate of the project. Payment of taxes results in cash flows and therefore, is
an important element in capital investment decisions. Income-tax has a number of
effects on capital investment decisions. Hence, tax laws and applicable legal decisions
emphasise the need for special skill in this area.

Secondary costs and benefits: These costs and benefits are particularly relevant for the
capital expenditure decision in public enterprises. They are external to the project
implementing body and there for called external cost and benefits, or simply
“externalities”. These are the costs and benefits, which are imposed on other sectors-
government, society or the economy as a whole – during the construction and operation
of the project and for which nothing is paid or received. There are two types of
externalities, viz., technological and pecuniary. The smoke and dust pollution and noise
etc., are examples of technological externalities pecuniary externalities are such as
increasing rates of hire for factors of production, reduction in prices of substitute
projects, etc. secondary benefits are the increase in profits that can be attributed to the
increased activity of processors, merchants and others who handle the project’s output
or input. The major problems associated with these costs and benefits are their
identification and measurement. However, for easy identification they should be related
to the socioeconomic objectives assigned to the project. To measure these costs and
benefits, shadow prices or imputed prices should be used.

Capital Expenditure Control

The control over capital expenditure is growing in importance as mechanization and

automation are introduced and extended. However, formal capital budgeting is still
undeveloped as it is of comparatively recent origin. Any system of capital expenditure
control should have the following feature.

Planned development: Capital expenditure should be carefully planned to include

developments in each site or department to ensure that each unit in the group or
company is developing in step with the overall plan preparation of capital budget will be
essential, even when companies to not operate a complete system of budgetary control.
Capital appropriations and payment must be planned well in advance.

Control of progress: A progress record is necessary to show the progress of each

capital project. The budget and actual expenditure will be compared for analysis and
control. These reports are also useful to ensure that the overall programme remains
within the limits set by the policy of the company.

Post-completion Audits: This is an important step of capital expenditure control. Post –

completion audits of projects determine. Where their actual value is in accordance with
the one determined at the time of authorization. This review can be very important
because it may reveal inefficiencies in the system, and it would provide experience
which would help in avoiding repetition of mistakes.

Forms and procedures: There should be a routine for controlling capital expenditure. A
procedure should be adopted for the various stages requesting for capital expenditures,
authorization, reporting the progress of such projects and audit. A well designed from
should be used for the above purposes for better control.

Methods of Ranking Investment Proposals

The final step in a the capital budgeting system involves evaluating the profitability of
the alternative project and selecting the best one. A firm may face a situation where
more investment proposals may be available than investible funds. Some proposals
may be good, some moderate, and many poor. Hence, a ranking procedure has to be
evolved so that the available funds can be allocated among different proposals in a
profitable manner. Essentially, the ranking procedure envisages relating of a stream of
future benefits to the cost of investments. Among the various methods, the following are
commonly used by many business concerns:

Traditional or non-time value techniques

i. Payback period
ii. Average rate of return
iii. Modern or time value techniques
iv. Discounted cash flow methods
v. Net present value
vi. Benefit / cost radio
vii. Internal rate of return

Payback period

Business units, while selecting investment projects, would consider the recover of cost
as the first and foremost concern, even though earning maximum profit is then ultimate
goal. Payback period normally refers to the time required for recouping the initial
investment in full with the help of the stream of annual cash flows generated by the
project. It is also called ‘pay-out or pay off period”, expressed, as:

Payback period (PB) = ------------

Where C = original coast of investment, and I = annual cash inflows.

In the case of uneven cash inflows it may be expressed as

PB = P = ∑

Where X represents cash flows during periods 0,1,2,.....P represents payback period.
The cash flows for the purpose of PB calculation, would be savings or earnings after
payment of taxes but before depreciation. To illustrate, if a cash outlay of Rs. 30,000 is
expected to yield a constant net cash flow (cash earnings minus cash expenses) of Rs.
12,000 P a for a period of 5 years, the PB is 2 ½ years (Rs. 30,000 + Rs. 12,000).

Selection criteria: Among the mutually exclusive or alternative projects whose PBs are
lower than the cut-off period, the project with the shorter PB would be selected. In case
there are budget constraints, the procedure would be to rank the projects in the
ascending order of PBs and select the first ‘X’ number of projects which the budget
provision permit. However, with a views to making the selection process more realistic,
a cut-off period or minimum payback ratio could be set up and all investment proposals
for which the PB is greater than this cut-off period be rejected. Payback ratio is the
inverse of the payback period. For a payback period of 4 years, the payback ratio is
1/4. Thus larger the payback ratio, better the project.

Illustration 1

From the following advise the management as to which project is preferable based on
payback period. The standard cut off period for the company is 5 years.

Project A Project B
Rs. Rs.
Capital cost 15,000 15,000
Cash flows (savings before depreciation, but after taxes)
Ist year 5,000 4,000
IInd year 5,000 4,000
IIIrd year 5,000 4,000
IVth year 2,000 3,000
Vth year 2,000 7,000
VIth year 2,000 9,000

21,000 31,000
Solution Project A Project B
Payback period = 3 years 4 years
(5,000 + 5,000 + 5,000 = 15,000) (Rs. 4,000 + 4,000 + 4,000 +
3,000 = 15,000)

The PBs of A and B are 3 years and 4 years respectively and thus project. A is
adjudged superior to project B in terms of PB criterion since it is also shorter than the
cut-off period.

Merits of payback period:

1. It is easy to operate and simple to understand

2. This method is preferred on the ground that returns beyond three or four years
are so uncertain that it is better to disregard them altogether in a planning
3. It is appropriate for industries with a high rate of technological obsolescence in
which the receipts beyond PB are regarded as totally uncertain.
4. This method is also useful to a concern which is short of cash and is eager to get
back the cash invested in a capital expenditure project.
5. As the method considers the cash flows during the payback period of the project,
the estimates would be reliable and the results may be comparatively more

Despite the simplicity and ease of operation, this method suffers from several


1. The PB is more a liquidity than a profitability concept, for it places accent only on
the recovery of cash outlay and stresses the importance of liquidity, that is
recovery at the cost of profitability.
2. It does not consider the earnings beyond the payback period. This may lead to
wrong selection of investment projects. Profitable projects with long gestation
periods or projects which generate high returns only after a certain period of time
may be rejected under this method.
3. The most serious limitation of this method is that it ignores the time value of
Average Rate of return Method (ARR)

ARR is considered to be an improvement over the PB method for it considers the

earnings of a project during its entire economic life. It is also known as ‘Return on
investment method’.
Average earnings or return
ARR = -------------------------------------------------- x 100
Average investment

The average return is computed by adding all the earnings after depreciation, and
dividing them by the project’s economic life. Average investment is the simple average
of the values of assets at the beginning and end of the useful life of the asset which in
most cases, Would be zero. Though sometimes initial investment is used, average
investment is more logical.

Selection Criteria: The decision rule is that a project with the highest rate of return on
investment is selected on condition that such rate is above the standard rate set, or the
cut-off rate.

Illustration 2

Calculate the average rate of return for project ‘A’ and ‘B’ from the following information.
Project A Project B
Invested (Rs) 25,000 37,500
Expected life (in years) 4 5
Net earnings (after depreciation and taxes)
1 2,500 3,750
2 1,875 3,750
3 1,875 2,500
4 1,250 1,250
5 -- 1,250

7,500 12,500

If the desired rate of return is 12%, which project should be selected?

Project A Project B
Average return Rs. 7,500 Rs. 12,500

4 5
-Rs. 1,875 Rs. 2,500
Average investment Rs. 25,000 + 0 Rs. 37,500+0

2 2
-Rs. 12,500 Rs. 18,750
Average rate of Rs. 1,875x100 Rs. 2,500x100
Rs. 12,500 Rs. 18,750
return -15% 13.33%

Both the projects satisfy the minimum required rate of return. However, if the projects
are mutually exclusive or alternative i.e. only one project is to be selected, project A will
be selected as its ARR is higher than project B. if they are not mutually exclusive, and
there are no budget constraints, both the projects will be selected.


1. This method is also easy to understand and simple to operate

2. The ARR method takes into account earnings over the entire economic life of the
3. This is really a profitability concept since it considers net earnings after
depreciation, i.e., excess of earnings over original cost of investment.
4. Projects which differ widely in characted could be compared under this system.

1. The most severe criticism of this method is that it ignores the time value of
2. Normally, a host of variants are to be resolved relating to its components viz.,
earnings and investment cost. For example, it may be the gross, net or average
investment which is to be considered for computation. This may produce different
rates of any one proposal.
3. Another problem in connection with the method is regarding a reasonable rate of
return on investments. Some stipulate a minimum rate so that if projects do not
satisfy this rate, they are summarily excluded from consideration.

Discounted Cash Flow (DCF) Method or Time Adjusted Technique

The discounted cash flow technique is an improvement on the pay-back period method.
It takes into account both the interest factor as well as the return after the pay-back
period. The method involves three stages.

i. Calculation of cash flows, i.e., both inflows and outflows (preferably after tax)
over the full life of the asset.
ii. Discounting the cash flows so calculated by a discount factor
iii. Aggregating of discounted cash inflows and comparing the total with the
discounted cash outflows.
iv. Discounted cash flow technique thus recognizes that Re 1 of today (the cash
outflow) is worth more than Re. 1 received at a future date (cash inflow)

Discounted cash floe methods for evaluating capital investment proposals are of three

(a) Net Present Value (NPV) Method

(b) Excess Present value Index (or) Benefit Cost Ratio
(c) Internal Rate of Return

NPV Method
This is generally considered to be the best method for evaluating the capital investment
proposals. In case of this method cash inflows and cash outflows associated with each
project are first worked out. The present values of these cash inflows and outflows are
then calculated at the rate of return acceptable to the management. This rate of return is
considered as the cut-off rate and is generally determined on the basis of cost of capital
suitably adjusted to allow for the risk element involved in the project. Cash outflows
represent the investment and commitments of cash in the project at various points of
time. The working capital is taken as a cash outflow in the year the project starts
commercial production. profit after tax but before depreciation represents cash inflow.
The Net present value (NPV) is the difference between the total present value of future
cash inflows and the total present value of future cash outflows.
The equation for calculation NPV is case of conventional cash flows can be put as

R1 R2 R3 Rn
NPV = ------ + ------- + -------- + ---------
(1 + k) (1 + k)2 (1 + k)3 (1 + k)n

Incase of non-convential cash inflow (i.e. where there are a series of cash inflows as
well cash outflows ) the equation for calculating NPV is as follows:

R1 R2 R3 Rn
NPV = ------ + ------- + -------- + ---------
(1 + k) (1 + k)2 (1 + k)3 (1 + k)n

11 12 13 1n
10 ------ + ------- + -------- + ---------
(1 + k) (1 + k)2 (1 + k)3 (1 + k)n

Where NPV = Net present value, R = Cash Inflows at different time periods, K Cost of
Capital or Cut-off Rate, 1 = Cash outflows at different time periods.

Accept or reject criterion. The net present value can be used as an accept or reject’
criterion. In cash the NPV is positive (i.e., present value of the cash inflows is more than
present value of cash outflows) the project should be accepted.


The Alpha Co. Ltd. is concidering the purchase of a new machine. The alternative
machines (A and B) have been suggested, each having an initial cost of Rs. 4,00,000
and requiring Rs. 20,000 as additional working capital at the end of 1 st year. Earning
after taxation are expected to be as follows:
Cash Inflows
Year Machine A Machine B
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000

The company has a target of return of 10% and on this basis, you are required to
compare the profitability of the machines and state which alternative you consider
financially preferable.

Note: The following table gives the present value of Re.1 due in ‘n’ number of years.

Year Present value at 10%

1 0.91
2 0.83
3 0.75
4 0.68
5 0.62
The Alpha Company
Year Discount Machine A Machine B
Cash Inflow Present Cash Inflow Present
Value value
Rs. Rs. Rs. Rs.
1 0.91 40,000 36,000 1,20,000 1,09,200
2 0.83 1,20,000 99,600 1,60,000 1,32,800
3 0.75 1,60,000 1,20,000 2,00,000 1,50,000
4 0.68 2,40,000 1,63,000 1,20,000 81,600
5 0.62 1,60,000 9,200 80,000 49,600

Total present value of cash inflow 5,18,400 5,23,200

Total present value of cash outflow 4,18,200 4,18,200

(Rs. 4,00,000 + 20,000 x 91)

Net present Value 1,00,200 1,05,000

Excess Present value Index : This is a refinement of the net present value method.
Instead of working out the net present value, a present value index is found out by
comparing the total of present value of future cash inflows and the total of the present
value of future cash outflows. This can be put in the form of following formula.

Excess Present Value Index.

Present value of future cash inflows

(Or) Benefits Cost (B/C) Ratio = ---------------------------------------------------------------- x 100
Present value of future cash outflows

Excess present value Index provides ready comparison between investment proposals
of different magnitudes. For example, ‘A’ requiring an investment of Rs. 1,00,000 shows
excess present value of Rs. 20,000 while another project ‘B’ requiring an investment of
Rs. 10,000 shows an excess on present value of Rs. 5,000. If absolute figures of
present values are compared, Project ‘A’ may to be profitable.
However, if excess present value index method is followed project ‘B’ would prov e to
be profitable.

Present Value Index for project A = ------------------------ x 100 = 120%

Present Value Index for Project B = ------------------------- x 100 = 150%


Internal Rate of Return is that rate at which the sum of discounted cash inflows equals
the sum of discounted cash outflows. In other words, it is the rate which discounts the
cash flows to zero. It can be stated in the form of a ratio as follows:

Cash Inflows
------------------- = 1
Cash outflows

Thus, in case of this method the discount rate is not known but the cash outflows and
cash inflows are known. For example, if a sum of Rs. 800 invested in a project becomes
Rs. 1,000 at the end of a year, the rate of return comes to 25% calculated as follows:

1 = -------------

I = Cash Outflow, i.e., initial Investment
R = Cash Inflow
r = Rate of return yoclded by the Investment (or IRR)


800 = ----------

Or 800r + 800 = 1,000

Or 800r = 200
Or r = ------------------ 25 or 25%

Cost of project Rs. 11,000
Cash inflow:

Year 1 6,000
Year 2 2,000
Year 3 1,000
Year 4 5,000

Find out Internal Rate of Return

F = --------------------

F= Factor to be located
I= Original investment
C= Average cash inflow per year

The ‘factor’ would be

F = -------------------- = 3.14

The factor thus calculated will be located in. Table II on the line representing number of
years corresponding to estimated useful life of the asset. This would give the estimate
date of return to be applied for discounting the cash inflows for the internal rate of
return. The rate comes to 10%.

Year Cash inflow Discounting Factor Present value

at 10%
1 6,000 0.909 5,454
2 2,000 0.826 1,652
3 1,000 0.751 751
4 5,000 0.683 3,415

Total present value 11,272

The present value at 10% comes to Rs. 272. The initial investment is Rs. 11,000.
Internal rate of Return may be taken approximately at 10%

In case more exactness is required another trial rate which is slightly higher than 10%
(since at this rate the present value is more than initial investment) may be taken.
Taking a rate of 12%, the following results would emerge.

Year Cash inflow Discounting Factor Present value

at 10%
1 6,000 0.893 5,358
2 2,000 0.797 1,594
3 1,000 0.712 712
4 5,000 0.636 3,180

Total present value 10844

The internal rate of return is this more than 10% but less than 12%. The exact rate may
be calculated as follows:
Difference in calculated
Present value and required
net cash only
Internal Rate of Return = ------------------------------------------- x Difference in rate
Difference in calculated
present values

11,272 - 11,000
= 10% + -------------------------------- x 2
11,272 – 10,844

= 10% + ------------- x 2 = 11.3%

The exact internal rate of return can be also calculated as follows:

At 10% the present value is + 272

At 12% the present value is – 156.

The internal rate would, therefore, the between 10% and 12% calculated as follows:

= 10 + --------------------- x 2
272 + 156

= 10 + 1.3 = 11.3%

Merits: The merits of discount cash flow method are as follows:

(i) Discounted cash flow technique take into account the time value of money
conceptually it is better than other techniques such as pay-back or accounting
rate of return.
(ii) The method takes into account directly the amount of expenses and revenues
over the project’s life. In case of other methods simply their averages are
(iii) The method automatically gives more weight to those money value which are
nearer to the present period than those which are father from it. While in case
of other methods, all money units are given the same weight which seems to
be unrealistic.
(iv) The method makes possible comparison of projects requiring different capital
outlays, having different lives and different timings of cash flows, at a
particular moment of time because of discounting of all cash flows.

Demerits: The following are the demerits of discounted cash flow method.

(1) The method is difficult to understand and work out as compared to other method
of ranking capital investment proposals.
(2) The method takes into account only the cash inflows on account of a capital
investment decision. As a matter of fact, the profitability or other wise of a capital
proposal can be judged. Only when the net income (and not the cash inflow) on
account of operations is considered.
(3) The method is based on the presumption that cash inflow can be invested at the
discounting rate in the new projects. However, this presumption does not always
hold goods because it all depends upon the available investment opportunities.


Marginal costing is a technique of ascertaining marginal costs or variable costs. it is not

a system for cost ascertainment, but is mainly a technique to deal with the effect on
profits of changes in volume or type of output. This technique may be used in
conjunction with other methods of costing. Marginal costing is also known as ‘direct
costing’ or ‘variable costing’. The latter expressions are mainly used in the United

Concept of Marginal Cost and Marginal Costing

The concept of ‘marginal cost’ has been borrowed from economic theory. To the
economist, marginal cost is an incremental cost: he considers it as the addition to total
cost which results from the production of one more unit of output. That is, it does not
arise if the additional unit is not produced.

The Institute of Costs and Management Accountants, London, defines marginal cost as:

“The amount at any given volume of output by which aggregate cost are changed if the
volume of output is increased or decreased by one unit.” As referred to here, a unit may
indicate a single article, a batch of articles, an order a stage of production capacity, a
processor a department, i.e., it relates to the change in output in the particular
circumstances under consideration.

Under marginal costing, costs are mainly classified into fixed costs and variable costs.
the essential feature of marginal costing is that the product or marginal costs (i.e., those
costs which are dependent on the volume of activity, are separated from the period or
fixed costs, i.e., costs which remain unchanged with a change in the volume of activity.
Variability with the volume of output is the main criterion for the classification of costs
into product and period categories. Even the semi-variable costs have to be bifurcated
into their fixed and variable components based on the variability criterion. In this regard,
the absorption or conventional costing system differs from marginal costing. Under
absorption costing system all manufacturing costs, whether of fixed or variable nature
are treated as product costs. all companies which use marginal costing as an aid to
managerial decision-making mainly use the absorption costing system.

Product X Product Y Total

Sales ................ ................ ...................
Less: Variable cost ................ ................ ...................

Contribution ................ ................ ...................

Less fixed cost ...................

profit --------------

From the marginal cost statement, the following equations may be derived:

Contribution = Sales – Variable cost

Contribution = Fixed cost + profit
Fixed cost = Contribution – profit
Fixed cost = Contribution + Loss
Contribution = fixed Cost + Loss
Sales = Variable cost + Contribution
Variable cost = Sales – contribution
Profit = Contribution – fixed cost
Loss = fixed cost – contribution

These equations may be used for solving problems of different types involving cost-
volume – profit relationship.

The Concept of Contribution and its Significance

Contribution is the difference net sales and marginal costs, and it is used to recover
fixed costs first. Any excess over fixed costs would be profits. When a business
manufacturers more than one product, the computation of profits realized on individual
products may be difficult due to the problem of apportionment of fixed costs to different
products., the rationale of contribution lies in the fact that fixed costs are done away with
under marginal costing. The concept of contribution helps to determine the breakeven
points, profitability of products, departments, etc., to select product-mix for profit
maximization, and to fix selling prices under different circumstances such as trade
depression, expert sales prices discrimination etc. contribution is the definite test to
ascertain whether a product or process is worthwhile to continue among different
products or processes.

Problem of Key Factor, or Measurement of Profitability

The contribution could be used as a measure to solve the problem of key factor. A key
factor, otherwise called ‘limiting factor’, or ‘principal budget factor’, or ‘scarce factor’,
may be defined as the factor which, over a period, will limite the volume of output, or
which puts a limit on the efforts of the management to produce as many units of the
selected products as it would like to when manufacture and sale of a product are
confronted by the problem of key factor, the profitability of that particular product is then
ascertained by relating the key factor used for the manufacture of the product, and its
resulting contribution. Generally, sales would be the limiting factor but sometimes,
materials, labour, plant capacity, etc., may be the inhibiting, factor when the key factor
and contribution are given, the relative profitability may be calculated by employing the
formula given below:

Profitability = ------------------------
Key factor

For example, when material is in short supply, profitability is determined by dividing the
contribution per unit by the quantity of materials used per unity when sales is the key
factor, profitability is measured by contribution sales ratio, and so on.

Advantages of Marginal Costing

(a) Marginal costing is easy to understand. It can be combined with standard costing
and budgetary control and thereby make the control mechanism more effective.
(b) Elimination of fixed overhead from the cost of production prevents the effect of
varying charges per unit, and also prevents the carrying forward of a portion of
the fixed overheads of the current period to the subsequent period. As such cost
and profit are not initiated and cost comparisons becomes more meaningful.
(c) The problem of over or under absorption of overheads is avoided.
(d) A clear-cut division of costs into fixed and variable elements makes the flexible
budgetary control system more easy and effective and thereby facilitated greater
particle cost control.
(e) If helps profit planning through break – even charts and profit graphs
comparative profitability can easily be assessed and brought to the notice of the
management for decision-making.
(f) It is an effective tool for determining efficient sales or production policies, or for
taking pricing and tendering decisions, particularly when the business is at a low
Managerial Uses of Managerial Costing:

From the advantages stated above, the following may be listed as specific
managerial uses:

(a) Cost Ascertainment: Marginal costing technique facilitates not only the recording
of costs but their reporting also. The classification of costs into fixed and variable
components makes the top of cost ascertainment more easy. The main problem
in this regard is only segregation of the semi-variable cost into fixed and variable
elements. However, this may be overcome by adopting any of the methods
already explained for the purpose.
(b) Cost control: Marginal cost statements can be understood more easily by the
management than those presented under absorption costing bifurcation of costs
into fixed and variable enables management to exercise control over production
cost and thereby effect efficiency. In fact, while variable costs are controllable at
the lower levels of management, fixed costs can be controlled at the top level.
Under this technique management can study the behaviour of costs at varying
conditions of output and sales and thereby exercise better control over costs.

Limitations of Marginal costing

Despite its superiority over absorption costing, the marginal costing technique has its
own limitations.

(a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a
major technical difficulty arises in drawing a sharp line of demarcation between
fixed and variable costs. the distinction between them holds good only in the
short run. In the long-run, however, all costs are variable.
(b) In marginal costing, greater importance is attached to the sales function thereby
relegating the production function largely to a secondary position. But, the real
efficiency of a business is to be assessed only by considering the selling and
production functions together.
(c) The elimination of fixed costs from the valuation of inventories is illogical since
fixed costs are also incurred in the manufacture of goods. Further, it results in the
understatement of the value of stock, which is neither the cost nor the market
(d) Pricing decision cannot be based on contribution alone. Sometimes, the
contribution will be unrealistic when increased production and sale are effected,
either through extensive use of existing machinery or by replacing manuallabour
by machines. Another possibility is that there is danger of too many sales being
effected at marginal cost, resulting in denial to the business of inadequate profits.
(e) Although the problem of over or under absorption of fixed overheads can by
overcome to a certain extent, the same problem still persist with regard to
variable overheads.
(f) The application of this technique is limited in the case of industries in which
according to the nature of business, large stocks have to be carried by way of
work-in-progress (e.g. contracting firms)

Practical Applications of Marginal Costing

(a) Profit Planning: A business concern exists with the objective of making profits,
and profits are the yardstick of its success profit planning is therefore a part of
operations planning. It is the basis of planning cash, capital expenditure, and
pricing. If growth and survival of a business are to be ensured, profit planning
becomes an absolute necessary. Marginal costing assists profit planning through
computation of contribution ratio. It enables planning of future operation in such a
way as to either maximize profits pre maintain specified levels of profit. Normally,
profits are affected by several factors, such as the volume of sales, marginal cost
per unit, total fixed costs, selling price and sales mix etc., Hence management
can achieve their profit goals by varying one or more of the above variables.
Basic marginal costing equations which are useful in profit planning are as

Profit volume ratio (p/w ratio). This is the ratio of contribution to sales. Symbolically it is
expressed as:

C/S ratio or P/V ratio = --------------------------------- x 100 (1)
(as a percentage) Sales (S)

Contribution = Sales x P/V ratio (2)

Sales = -------------------------- (3)
P/V ratio

Brake Even point (BEP). This may be defined as that point of sales volume at which
total revenue is equal to total costs. it is a no-profit no-less point. It may be derived from
the equation (3). We may get

Contribution at BEP
BEP (in Rs.) -----------------------------
P/V ratio

At BEP, the contribution will be equal to fixed cost and therefore, the formula may be
restructured as follow:

Fixed Cost
BEP (in Rs.) = ---------------------------
P/V ratio

Fixed Cost (F)

BEP (in units) = -----------------------------
Contribution per unit

Margin of Safety (MS) : This represents the difference between salew or production at
the selected activity, and the break-even sales or production.

MS = Sales at the selected activity --- BEP

Sales at the selected activity = ----------------------
P-V ratio

BEP = ----------------------
P/V ratio

C F profit (p)
MS = ------------------------- ------------ ------------------- = ---------------------------
P/V ratio P/V ratio P/V ratio

Where C-F = P
Margin of safety is also presented in percentages as follows:
MS (Sales) x 100
Sales at selected activity

Illustration 2
From the following information, calculate BEP and determine the net profit if sales are
25% above BEP

Selling price per unit Rs. 50

Direct material cost per unit Rs. 20
Direct wages per unit : Rs. 10
Variable overheads per unit : Rs. 7.5
Fixed overheads (total) Rs. 50,000


Marginal Cost Statement

Selling price per unit 50.00
Less: marginal cost per unit Rs.
Materials 20.00
Wages: 10.00
Variable overheads: 7.50 37.50
Contribution: 12.50

C 12.50
P/V ratio = ------------- x 100 = ---------------- x 100 = 25%
S 50
F Rs. 50,000
BEP = ---------------- = ----------------------- x 100 = 2,00,000
P/V ratio 25

BEP = Rs. 2,00,000

25% of BEP = Rs. 50,000
Total sales Rs. 2,50,000

Contribution = Sales x P/V ratio

Contribution at Rs. 2,50,000 sales = Rs. 2,50,000 x 25%

Contribution = Rs. 62,500

Less: Fixed cost = Rs. 50,000

Net profit = Rs. 12,500

(b) Level of Activity Planning

Business concern may have plans either to expland or contract the level of activities
depending upon the conditions prevailing in the market. Such planning is to be
considered before events overtake the business. Marginal costing is very useful for
taking such decisions by enabling management to compare the contribution at different
levels of activities.
Illustration 5

Following is the Cost Structure of JB limited

Levels of Activity

Output (in puts) 60% 70% 80%

2,400 2,800 3,200
Costs (Rs.)
Materials 48,000 56,000 64,000
Wages 14,400 16,800 19,200
Factory overheads 25,600 27,200 28,800

Factory cost 88,000 1,00,000 1,12,000

The factory is considering an increase of production to 90% level of activity. No increase

in fixed overheads is expected at this level. The management requires a statement
showing all details of factory costs at 90% level of activity.

Marginal Cost Statement

Level of activity = 90%
Output = 3.600 units
Total cost Per unit

Rs. Rs.
Material 72,000 20.00
Wages 21,600 6.00
Variable overheads 14,400 4.00
1,08,000 30.00
Fixed overheads 16,000
Total factory cost 1,24,000

Note: Factory overheads increase by Rs. 1,600 at each level of activity. Therefore,
variable overheads must be

Rs. 1,600
----------------- = Rs. 4 per unit. At 80% level of activity, Factory overheads
400 units

are Rs. 28,800 of which variable cost are Rs. 12,800 (Rs. 4 x 3,200), resulting in fixed
overheads of Rs. 16,000 (Rs. 28,800 – Rs. 12,800).

(D) Profitable Mix of Sales

A company which has a variety of product lines can employ marginal costing in order to
determine the most profitable sales mix from a number of selected alternatives.

Illustration 6
The directors of AB Ltd. are considering the sales budget for the next budget period.
The following information has been made available form the cost records.

Product Z Product Y
(per unit) (per unit)
Directed materials Rs. 40 Rs. 50
Selling price Rs. 120 Rs. 200
Direct wages (a)
Rs. 2 per hour 10 hours 15 hours

Variable overheads : 100% of direct wages

Fixed overheads : Rs. 20,000 p.a.

You are required to present to the management a statement showing the marginal cost
of each product, and to recommend which of the following sales mix should be adopted.

(a) 450 units of Z and 300 units of Y

(b) 900 units of Z only
(c) 600 units of Y only
(d) 600 units of Z and 200 units of Y

Marginal cost statement

Per unit
Product Z Product Y
Rs. Rs. Rs. Rs.
Selling price 120 200
Less: Materials
Direct materials 40 50
Direct wages 20 30
Variable 20 80 30 110
40 90

Selection of Alternatives
Z Y Total
Rs. Rs. Rs.
450 – 300 – Y 18,000 27,000 45,000
(450 x Rs. 40)
+ (300 x Rs.
Less: Fixed 20,000
Profit 25,000
900 – Z
Contribution 36,000 36,000
(900 x Rs. 40)
Less fixed cost 20,000
Profit 16,000
(c) 600 – Y 54,000 54,000
(600 x Rs. 90)
Less: fixed cost 20,000

Profit 34,000

600 – Z, 200 – 24,000 18,000 42,000

Y Contribution
(600 x Rs. 40) 20,000
+ (200 x Rs.
90) Less: Fixed

Profit 22,000

Thus, alternative (c) is the one recommended.

(d) Marginal Costing and Pricing

Determining the price of products manufactured by a company is often considered to be

a difficult problem. However, the basic problem involved in pricing is the matching of
demand and supply. Marginal costing is something used to determine prices, a simple
and familiar example being the railway ticket. The normal fare will usually be more than
the charge collected for excursion fare (concessional fare) for, the normal fare is
calculated to cover all the railway costs, including fixed overheads which are a
considerable item, whereas the excursion fare will probably cover only the marginal cost
(which is relatively small) and some contribution towards profit. The marginal costing
technique can help management in fixing price in such special circumstances as:

(a) A trade depression in the industry.

(b) Spare capacity in the factory
(c) A seasonal fluctuation in demand.
(d) When it is desired to obtain a special contract.

Cost – volume – profit Analysis

Cost – volume – profit (CVP) analysis is an analytical tool for studying the relationship
between volume cost, price and profits. It is an integral part of the profit planning
process of the firm. However, formal profit planning and control involves the use of
budgets and other forecasts, and the CVP analysis provides only an overview of the
profit planning process. Besides, it helps to evaluate the purpose and reasonableness
of such budgets and forecasts. Generally, CVP analysis provides answers to questions
such as:

(a) What will be the effect of changes in prices / costs and volume on profit?
(b) What minimum sales volume need be effected to avoid losses?
(c) What should be the level of activity to earn a target profit?
(d) Which product is the most profitable and which product or operation of a plant
should be discontinued? Etc

Break – Even Analysis

The break-even analysis is the most widely known from of the CVP analysis. The
study of CVP relationship is frequently referred to as break-even analysis. However,
some state that up to the point of activity where total revenue equals total expenses, the
study can be called as break-even analysis and beyond that point, it is the application of
CVP relationship.

Thus, a narrow in depredation of break-even analysis refers to a system of determining

that level of activity where total revenue equals total cost i.e. the point of zero loss. The
broader interpretation denotes a system of analysis that can be used to determine the
probable profit at any level of activity.

Practical Utility of Break-even Analysis

Break-even Analysis can be used to show the effect of a change in any of the following
profit factors:

(1) Change in selling price

(2) Change in volume of sales
(3) Change in variable costs
(4) Change in fixed costs


Information is the basis for decision making in an organisation. The efficiency of

management depends, to a larger extent, upon the availability of regular and relevant
information to those exercise the managerial functions. No planning and control
procedure is complete without prompt and accurate feedback of operation results and
availability of other information. For example, management must know how the actual
profit performance collates with that of budgeted or standard or with past performances
and to what extant the variation have been caused by various influencing factors. A
regular system of reporting is considered as a better guarantee of efficiency and
operation than reliance on personal qualities. Hence, it is essential that an effective and
efficient reporting system is developed as part of accounting methods.


The term ‘reporting’ connotes different meanings as under:

(A) Narrating some facts

(B) Reviewing certain matter with its merits and demerits and offering comments.
(C) Furnishing data at regular intervals in standards form.
(D) Submitting specific information for particular purpose upon specific request

Management reporting refers to the formal system whereby relevant required

information is furnished to management by means of reports constantly. Thus, ‘report’ is
the essence of any management reporting system.

The term ‘Report’ normally refers to a formal communication which moves upward, i.e.,
for factual communication by a lower to a higher level of authority in response to order
received from higher level. Reports provide means of checking the performance. A
person, who is issued with orders or instructions to do certain things should report back
what he has done in compliance thereof. Reports may be oral or written and also
routine or special.
Objects of Reporting
The primary object of management reporting is to obtain the required information about
the operating results of the organisation regularly in order to use them for future
planning and control. Another object is to secure understanding and approval of the
judgment by the people engaged in various aspects of the work of enterprise. The
second object is closely related to the first one and is important in terms of efficiency,
morale and motivation.

Essentials of a Good Reporting System

Reporting system enables management at all levels to keep itself abreast of past
performance as well as developments and it facilitates a check on individual operating
levels. Based on reports, management takes crucial decisions. Hence, the essentials of
good reporting system are as follows:

1. Proper form: In order to facilitate decision-making the information should be

supplied in form.
2. Proper time: Promptness is very important because information delayed is
information denied Reports are meant for action and when adversetendencise or
events are noticed, action should follow forthwith. The sooner the report is made
the quicker can be the corrective action taken.
3. Proper flow of information: The information should flow from the right level of
authority to the level of authority where the decision are to be made. Further a
complete and consistent information should flow in a systematic manner.
4. Flexibility: The system should be capable of being adjusted according to the
requirement of the user.
5. Facilitation of evaluation: The system should distinctively report deviations from
standards or estimates. Controllable factors should be distinguished from non-
controllable factors and reported separately.
6. Economy: There is a cost for rendering information and such cost should be
compared with benefits derived from the report or loss sustained by not having
the report. Economy is an information aspect to be considered while developing
reporting system.

Models of Reporting

Reports may be presented in the form of written statements, graphs, abd or oral.

1. Written statements
a. Formal financial statements: These statements may deal with any one or
more of the following:
i. Actual against the budgeted figures.
ii. Comparative statements over a period of time
b. Tabulated statistics: This statement may deal with statistical analysis of a
particular type of expenditure over a period of time or sales of a product
over a period in different regions, etc.
c. Accounting ratios: The ratios may either form part of the formal financial
statement or be given in the form separate statement.
2. Graphic reports
The information may be presented by means of graphic reports which give a
better visual view of the data than the long array of figures given instatements.
Charts, diagrams and pictures are the usual form of graphic reports. They have
the advantage of facilitating quick grasp of significant trends by receivers of

3. Oral reports
Oral reports are mostly presented at group meetings and conferences with

Basic Requisites of a Good Report

A report is a vehicle carrying information to different levels of administration. Quality of

decision-making depends to a large extent on the quality of information supplied and on
the promptness and consistency of reporting. Good reporting is necessary for effective
communication. hence a good report should possess the following basic requisites.

1. Promptness: It means that report must be prepared and presented on time.

2. From and content: A good report should have a suggestive title, headings, sub-
headings, paragraph divisions, statistical figures, facts, dated etc.
3. Comparability: Reports are also meant for comparison.
4. Consistency: consistency envisages the presentation of the same type of
information as between different reporting periods. Uniform procedure should be
followed over period of time.
5. Simplicity: The report should be in a simple unambiguous and concise form
6. Controllability: It is necessary that every report should be addressed to a
responsibility centre and present controllable and uncontrollable factors
7. Appropriateness: Reports are sent to different levels of management and the
form should be designed to suit the respective levels.
8. Cost considerations: The cost of maintaining the reporting system should
commensurate with the benefits derived there form.
9. Accuracy: The report should be reasonably accurate.

Types of reports

Routine Reports

Reports which are submitted at periodical intervals on a regular basis covering routine
matters e.g., variance analysis, financial statements, budgetary control statements are
routine reports.

Special Reports

Reports which are submitted on particular occasions on specific request or instruction

are special reports.

Operating Reports
These reports may be classified into control report information – cum-venture
measurement report.

Control Report
It is an important ingredient of control process and helps in controlling different activities
of an enterprise. It provides information properly collected and analyzed to different
levels of management.

Information Report
These reports provide information which are very much useful for future planning and
policy formulation.

Financial Reports
These report contain information about the financial position of the business. They may
be classified into Static Reports and Dynamic Reports. Static reports reveals the
financial position on a particular data e.g., balance sheet of a company. On the other
hand, the dynamic report reveals the movement of funds during a specified period e.g.
Fund flow statement, Cash flow statement.


Time: 3 Hours Max. marks: 100
PART – A (6 x 5 = 30)
Answer any SIX questions
All questions carry Equal marks
Each answer to a theory question need not exceed One page

1. State the significance of management accounting.

2. What are the limitations of financial statements?
3. What is debt service coverage ratio?
4. State the significance of capital budgeting?
5. What is common size financial statements?
6. Determine which company is more profitable.
A Ltd. B Ltd
Net profit ratio 5% 8%
Turnover ratio 6 times 3 times
7. Calculate the funds from operations from the following profit and loss account:
P & L A/c
To Salaries 5,000 By Gross profit 50,000
To Rent 3,000 By Profit on sale of 5,000
To depreciation on plant 5,000
To Printing & Stationary 3,000
To Goodwill written off 3,000
To Preliminary expenses 2,000
written off
To Provision for tax 10,000
To Net Profit 24,000
55,000 55,000
8. Calculate from the following information the break-even point and the net profit if
the sales volume is Rs. 8,00,000, P/V ratio is 40% and margin of safety is 25%.
9. Prepare a production budget for three months ending March-31, 1999 for a
factory producing four products, on the basis of the following information:

Types of product Estimated stock Estimated sales Desired closing

on 1 – 1 – 1999 during Jan – Stock on 31-3-99
(units) March 1999 (units) (units)
A 2000 10000 3000
B 3000 15000 5000
C 4000 13000 3000
D 3000 12000 2000

PART – B (5 x 14 = 70)
Answer any FIVE questions
All questions carry EQUAL marks
Each answer to a theory need not exceed Three pages.

10. What is budgetary control? What are the objectives and advantages of budgetary
11. Discuss the different methods of ranking investment proposals.
12. What are the functions of management accounting?
13. X Ltd., furnishes you the following information:
Year 1998
I Half II Half
Sales Rs. 8,10,000 10,26,000
Profit 21,600 64,800

From the above you are required to compute the following assuming that the fixed
cost remains the same in both the periods:
i) P/V ratio
ii) Fixed cost
iii) The amount of profit or loss where sales are Rs. 6,48,000
iv) The amount of sales required to earn a profit of Rs. 1,08,000
v) From the balance sheets of A Ltd.; make out i) a statement of changes in the
working capital and ii) Fund Flow statement.

1995 1996 1995 1996

Share Capital 4,50,000 5,00,000 Goodwill 1,15,000 90,000
General reserve 40,000 70,000 Plant 80,000 2,00,000
Profit & Loss A/c 30,000 48,000 Buildings 2,00,000 1,70,000
Creditors 97,000 1,33,000 Debtors 1,60,000 2,00,000
Bills payable 20,000 16,000 Stock 97,000 1,39,000
Provision for Tax 40,000 50,000 Bank 25,000 18,000
6,77,000 8,17,000 6,77,000 8,17,000